Income opportunities in the high yield bond market - Global bonds and currencies

High yield income as an alternative to equity income

We have made the case over the last year that, in this period of low growth, investors may benefit from equity income strategies. Alongside the rationale for this case, at Newton we believe that high yield bonds may provide an attractive alternative for investors. Exhibit 1 shows the cumulative returns of the U.S. high yield market³ as compared to the FTSE 100, S&P 500 and S&P 500 Dividend Aristocrats indices⁴ on a total return basis from October 2001 to the end of October 2011. The returns over this period of the FTSE 100 and S&P 500, at around 61% and 47% respectively, are well below the S&P 500 Dividend Aristocrats index return of around 108%. However, the U.S. high yield index has achieved the highest cumulative return of 141%, with an annualized return of 9.1%⁵.

When assessing the attractiveness of an asset class, we believe that return should not be the sole element of consideration: volatility also needs to be taken into account. As Exhibit 2 illustrates, high yield bonds have exhibited a lower level of volatility than the equity market indices assessed. Throughout most of the last decade, the volatility of high-yield bonds has been lower than that of the main developed-market equity indices. In late 2008, high-yield volatility increased to match that of equity indices, as the corporate bond market suffered severe dislocation following the effects of the Lehman Brothers' bankruptcy⁶. However, since mid-2009, that volatility among high-yield bond markets has reduced significantly, and over the last couple of years has returned back to a level below that of equity indices.

We observe from Exhibits 1 and 2 that, on a risk-adjusted basis, high-yield bonds have provided a higher return over the last 10 years than the main developed market equity indices⁷. We believe that high-yield bonds comprise further attractive features, such as the fact that payment of coupons is a contractual obligation, rather than a discretionary decision and that typically, at maturity, investors, must be repaid at par. The biggest worry for high yield investors is defaults and restructurings, which may result in coupons being unpaid and investors being asked to take a 'haircut' on their principal investments (i.e. accept a lower payment at maturity than the amount originally invested). However, we believe the outlook for high yield corporate bonds remains positive.

Default rates

We believe the default rate environment in the high yield market for the next 12-18 months looks very benign: Moody's expects a rate of around 2% for the next 12 months. The key reasons behind this low default expectation are good progress in refinancing and strong corporate balance sheets⁸.

As demonstrated by the charts in Exhibit 3, over the last couple of years, the majority (around 70%) of issuers use the proceeds of new debt issues for refinancing and not for general corporate purposes or acquisitions. We believe leverage continues to be on a downward trend as managements increase their focus on improving creditworthiness. We believe both of these elements are positive for credit, as they help to maintain sound balance sheets.

High yield performance in a low growth world

The "sweet spot" for high yield is, we believe, real economic growth in the range of 1-2%. Above 2%, we observe that economic expansion usually leads to an increase in underlying government yields and is usually inflationary; both of these factors, we believe, start to erode the credit spread available on the asset class. Furthermore, in such an environment, there is usually an asset allocation shift away from high yield into equities, which is clearly unfavorable for the asset class⁹. On the other hand, we believe sustained real economic growth of below 1% will usually result in an improvement in default rates, which is negative for the asset class. A level of 1-2% real economic growth seems to us to be the optimum range, as the income from the asset class is attractive and growth seems to us to be not low enough to spur an increase in default rates. Moreover, such low-growth periods tend to result in significant volatility in markets¹⁰, which we believe discourages leveraged buy-outs and heavy capital expenditure, and forces managements to maintain stronger balance sheets. Also, we believe that such an environment forces investment-grade companies to pursue growth through acquisitions, an activity from which high yield corporate bonds tend to benefit. In a low-growth environment, we believe the focus should be on companies which are cash generative, have a robust asset base and do not require top-line growth to be able to grow into their capital structure. In conclusion, even if high-yield credit spreads do not contract in this environment, we believe the income is attractive enough to justify remaining invested.

Index definitions

Merrill Lynch Global High Yield Constrained

Contains all securities in the Merrill Lynch Global High Yield Index, but caps issuer exposure at 2%. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face values of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. In the event there are fewer than 50 issuers in the Index, each is equally weighted and the face values of their respective bonds are increased or decreased on a pro-rata basis.

S&P 500

An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor's. The S&P 500 is a market value weighted index - each stock's weight is proportionate to its market value.

S&P 500 Dividend Aristocrats

Measures the performance of S&P 500 index constituents that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years. Stocks are equally weighted, with constituents re-weighted each quarter.

FTSE 100

Comprises the largest 100 companies by market capitalisation in the FTSE All-Share Index. The FTSE All-Share is a market-capitalisation weighted index of UK equities, representing the performance of all eligible companies listed on the London Stock Exchange's main market, which pass screening for size and liquidity.