Possible buying opportunity for high-yield bonds

2 mins. to read
Possible buying opportunity for high-yield bonds

The flight to safety has sent high-yield bond prices plummeting, but the market may well have over reacted.  

It is not just share prices that have been caught up in the mayhem, with high-yield bonds also experiencing heavy falls. The funds that invest in this area are now typically yielding four to seven percent, which when compared to Treasuries suggests that the market is anticipating an unprecedented increase in corporate defaults.

There is no doubt that some of these companies will go bust, but many will survive just like they did after the financial crisis of 2008/09. Much of the selling has been indiscriminate as investors just needed to get their money out and this has created an ideal hunting ground for the experienced managers that operate in this area.

Heavy selling during the initial rout

Many high yield bonds experienced heavy selling during the initial rout at the end of February, yet the intervention by the US central bank has done a lot to restore confidence. Prices have partially recovered, but the funds operating in the sector are still down between four and twenty percent in the last three months.

It is important to remember that companies are legally obliged to meet the coupon and principal payments on their debt, whereas dividends are discretionary and have suffered widespread cuts. This suggests that investors should have greater confidence in the security of the income offered by the bonds rather than the shares.

One of the least risky funds operating in the sector is Royal London Short Duration Global High Yield Bond. In recent years it has offered a cash-like total return of LIBOR plus around 2.5%, yet it is down 7.6% in the last three months and is now yielding 4.9% according to FE Trustnet.

In their recent quarterly review, the managers said that the market went into panic mode at the end of February. Because of this the high-yield spread – the difference between the yield on Treasuries and equivalent maturity high-yield bonds − moved to its widest level since the financial crisis and breached 1,000 points, having been close to its tightest post-crisis level the month before.

Liquidity-driven downturn

The energy and leisure sectors were particularly badly affected for obvious reasons, but other than that the downturn was largely liquidity-driven. There has since been a notable rally following the intervention by the US central bank, although prices are still significantly lower year-to-date.

The Royal London Short Duration fund tends to invest in the most liquid bonds available in the high yield space, which made them obvious targets for investors who needed to raise cash quickly. Even its most stressed holdings typically have enough cash to survive for up to six months with little or no revenues, hence the default rate for the portfolio should be far lower than is being priced into the high-yield market as a whole.

In order to protect themselves against liquidity risk the managers have built up a significant cash balance of circa 20% and lowered the duration of the fund even further. They will be able to reduce the cash buffer if the recovery proves to be sustainable.

Royal London Short Duration Global High Yield Bond appeals because of the liquid, short duration nature of the holdings and the low exposure to vulnerable areas like the energy and automotive sectors. The larger and better quality issuers that it invests in have suffered because their bonds were tradable, which suggests that this could be a decent entry point for investors who can tolerate the inevitable volatility.

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