Donald Phillips

High yield: all about that income

Donald Phillips

With income the sole driver of long-term high-yield bond returns, this asset class can offer a fresh option for income-hungry investors concerned about dividend cuts.

Excluding a few niche parts of the market, the majority of high-yield coupons are mandatory, whereas recent months have starkly highlighted the discretionary nature of equity dividends. For us, high yield continues to exemplify both the fixed and the income elements of the bond universe and, as the chart below shows, also offers among the best risk-adjusted return profiles across the debt spectrum, with superior yield and lower interest rate sensitivity.

Global fixed income yields and durations

This argument is supported by the performance of high yield versus UK income funds over recent periods, with the IA Sterling High Yield sector comfortably ahead of the IA UK Equity Income peer group over one, three and five years to the end of August 2020, returning 0.7% versus -12.4%, 7.1% versus -12.3% and 21.3% versus 6.4% respectively*. Since inception in June 2018, our Liontrust GF High Yield Bond Fund is also ahead of the UK Equity Income and Global Equity Income sectors with less volatility, producing 10.7% against -16.9% and 6.7% respectively**.

We look at high yield as a middle ground between equities and bonds, a kind of cousin of the former, and while spreads  a broad proxy for the yield in high yield have come down from recent highs, they are still 75% above February levels. With sovereign debt basically paying nothing at present, and actually costing investors relative to inflation, and dividend cuts and suspensions by so many listed companies, high yield offers an attractive, alternative source of income. We are confident of our Fund delivering a yield of around 5%, even with defaults generally rising in the wider economy.

Before coming to those default concerns, we want to address another challenge raised by clients. Some investors can be reluctant to commit money to high yield because they are waiting for the optimal entry point based on macro conditions. But this can risk missing out on high yield’s best characteristics by ‘renting’ the asset class over short periods in the hunt for quick capital gains rather than ‘owning’ an income provider for the long term. Attempting to time entry into high yield as a tactical allocation call is largely about luck and very few people ever get such decisions consistently right in any asset class.

Performance from global high yield has been 100% from income over the last decade: to the end of July 2020, the sector’s near 7% annualised return was made up of 6.92% income, with a small loss (-0.16%) in terms of price return***. This shows defaults had very little impact on overall long-term performance.

Defaults are obviously something to watch given the current environment but we are an active manager and believe this risk can be alleviated. High yield is efficient enough to identify companies most at risk of default and the market is trading accordingly. If we say any bond with a 10% spread or higher is seen as particularly at risk of default, this accounts for just 7% of the global market, and we are confident of producing an attractive yield without having to look at the higher-risk end.

Segmenting the global high-yield universe, the highest risk and yields can largely be found in more cyclical sectors, and our Fund remains significantly underweight these areas compared to the ICE BAML Global High Yield Index. Investors might ask why a high-yield fund is not seeking opportunities in the highest-yielding parts of the market but these are exactly the kind of thematic risks we want to avoid and expect these sectors to dominate the default picture.

With energy, for example, which is a large weight in high-yield indices, the key factor at present is the high costs of production versus current spot hydrocarbon prices, meaning these companies are very sensitive to geopolitics, economic recovery and a potential Covid-19 vaccine. Managers of these businesses have very little control over these risks.

Apart from energy, we also have modest exposure to the lowest-rated CCC bonds and focus instead on more resilient and idiosyncratic opportunities. Media is the largest overweight sector in the portfolio, for example, which we see as a broad mix of defensive and cyclical businesses, and other favoured areas include insurance, telecoms and capital goods.

During the recent earnings season, it has been notable how resilient our holdings have been. Top-line sales have obviously taken a hit across the board, and yet many companies have had a relatively decent margin outcome and cashflow dynamics have been broadly solid, further proving the strength we identified when initially investing. Even one of our few more cyclical holdings, auto parts distributor LKQ, provides a good example of this: sales were down close to 20% but operating margin only fell by 50 basis points and the company generated close to $700 million in cash by running inventories down.

Our stance since the launch of the Fund in avoiding accumulations of thematic, cyclical businesses and preferring idiosyncratic, less economically sensitive companies has been rewarding for clients to date and sets us up to avoid defaults over the coming months.

We also monitor the percentage of our portfolio that is stock market listed and the market cap of these holdings. As evidence of the quality of the Fund, the current 81% that is in bonds issued by listed businesses has an average market cap of $38 billion, far ahead of the average FTSE 100 company at $22 billion. From a process point of view, this provides comfort in the sources of capital available to our portfolio holdings; from a client perspective, we find this useful in combatting the idea that the high-yield market is junk and defaults are an impediment to making money from the asset class.

If you can avoid companies that default via an active quality-focused approach, high yield can offer attractive performance versus equities or bonds, either for long-term total return accrual (largely via income) or to replace the income currently missing elsewhere.

Discrete 12-month performance to last quarter end (%)****:

 

 

Jun-20

Jun-19

Liontrust GF High Yield Bond C8 Acc

-1.2

7.3

ICE BofAML Global High Yield Hedge GBP

-1.6

6.5

 

Discrete data is not available for five full 12-month periods due to the launch date of the portfolio.

 

*Source: FE Analytics, as at 31.08.20.

 

**Source: FE Analytics, C8 share class, total return, net of fees and interest reinvested. 08.06.18 to 31.08.20.

 

***Source: Bloomberg, ICE BofA Global High Yield Index annualised return, 10 years to 31.07.20.

 

****Source: Financial Express, C8 share class, total return, net of fees and interest reinvested. As at 30.06.20.


Liontrust Insights

 

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, September 10, 2020, 12:37 PM