After several years of strong returns in the high yield bond market, yields are currently at a very low level. Today, the challenge facing investors is how to navigate such low yields, in a market where bond prices are high. In the Henley Fixed Interest team’s opinion the low levels of yield, on the whole, do not adequately compensate investors for the risks of investing. Nevertheless, we continue to find bonds within the market that we believe do offer attractive value.
When investing in the high yield bond market our approach is to select bonds based on fundamental analysis. High yield bonds are issued by companies with leveraged balance sheets, and that leverage can create additional risks. It may sound fairly obvious but our primary focus is to understand the credit profile of the companies we invest in, something that becomes more relevant the further we move away from the higher quality, lower yielding investment grade bonds. A key element is understanding the cash flows of those companies; as lenders we need to make sure that first of all we will be paid the interest on a bond, and secondly that we will be repaid at the maturity of that bond. Other factors to consider will be the business and industry outlook, management team, ownership and the legal protections afforded to the bond. Once we feel that we have a good understanding of the risks, we can then move on to consider the yield that a high yield bond is offering.
Looking for opportunities
So, where do we look for opportunities in a market like this? With yields so low in the high yield market, the priority now is to think about what can go wrong from here for the companies we’re looking at. That might mean avoiding companies with leveraged balance sheets in sectors that have the potential for more volatile earnings, such as oil, commodities or chemicals. We’re not necessarily avoiding any sectors but we are being very selective within them.
One area that can provide us with good opportunities is the new bond issue, or primary, market. New issues may pay a yield premium over existing bonds for a variety of reasons. For example, a bond issuer coming to the market for the first time may have to pay a premium because the company is not well known. Puregym, the UK’s largest gym operator and the pioneer of the value gym concept in the UK is a good recent example. Puregym came to the market in January 2018 and raised £360m through a 6-year bond paying a coupon of 6.375%. In our opinion the coupon on that bond was set at a decent premium over similar bonds in the market because Puregym was a first time issuer. We consider every new issue that is printed in the high yield market, although our highly selective investment approach means that we will not participate in all new issues.
More broadly, both City Merchants High Yield Trust Limited and Invesco Perpetual Enhanced Income Limited have exposure to bank capital bonds, where we believe the yield on offer is still attractive relative to the risks. Since the financial crisis the banking industry has made a huge amount of progress in raising capital and fixing balance sheets. However, as with other parts of the market, yields have also fallen significantly on these bonds.
Balancing risk and return
Finally, in terms of credit ratings, we think the balance of risk and return is perhaps best achieved by bonds rated single B. By contrast, the price of double B rated bonds have, in our view, been distorted by investment grade issuers seeking yield following central bank purchases of investment grade corporate bonds. At the other end of the spectrum, CCC rated bonds do not generally offer enough yield for us to be comfortable. Of course there are exceptions to this, and our primary focus is always on individual bond selection. For example, we have recently purchased CCC-rated bonds issued by Matalan, a company we are very familiar with and where we believe that the yield offers sufficient compensation for the additional risk of investing in the lower grade bond.
Looking ahead, we think that it is important to be mindful of expectations for returns in 2018. We are entering a phase where central banks are indicating a withdrawal of monetary support, the economic environment is relatively strong and yields are at very low levels. Similar to 2015, income may well provide the main component of returns for the high yield market this year. The low yield environment creates obvious challenges for investing but we believe that we can continue to find opportunities to invest at reasonable value. Good credit analysis will be key to managing the portfolios through this period.
By adopting this tried and tested approach we believe that we will be able to meet the challenges that the ongoing environment of historically low yields poses, and seek to continue to deliver attractive levels of income for our clients.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
When making an investment in an investment company you are buying shares in a company that is listed on a stock exchange. The price of the shares will be determined by supply and demand. Consequently, the share price of an investment company may be higher or lower than the underlying net asset value of the investments in its portfolio and there can be no certainty that there will be liquidity in the shares.
The portfolios have a significant proportion of high-yielding bonds, which means that there is more risk to investors’ capital and income than from a Company investing in government or investment-grade bonds. Income from the investment may fluctuate and is not guaranteed. The Companies may invest in derivatives. This means that the net asset value of the Companies may, at times, be highly volatile. The use of derivative instruments involves certain risks (including market or communication breakdown, counterparty failure and credit risk) and there is no assurance that the objectives for the use of such instruments will be achieved.
The Companies may use borrowings to invest in the market. The use of borrowings may enhance total return when the value of the Companies assets is rising, but it will have the opposite effect when asset values fall. The use of borrowings may increase the volatility of the share price and the net asset value per share. In certain circumstances, the investment companies may be required to repay borrowings and this could adversely affect income and capital returns. The portfolios may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
All data is at 28 February 2018 and sourced from Invesco Perpetual unless otherwise stated.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
For more information on our products, please refer to the relevant Key Information Document (KID), Alternative Investment Fund Managers Directive document (AIFMD), and the latest Annual or Half-Yearly Financial Reports. This information is available using the contact details shown.
This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Issued by Invesco Fund Managers Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.
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