High Yield Bonds: The importance of being prudent and patient

Negotiations with major trading partners such as China and the EU are ongoing, and the only finalised deal so far is with the UK. Even if agreements are reached, some residual tariffs may remain, as seen in the UK’s experience. There’s also the risk that negotiations could collapse. While these scenarios could hinder economic growth, the market seems to be acting as if the tariff risks have already disappeared.

Additionally, there is a possibility that the U.S. government could shut down over the summer unless the debt ceiling is raised and a new budget is approved by Congress. Investors appear to interpret an expansionary budget as a positive for risk markets, as increased government spending injects liquidity into the system. However, this could stoke fears of an unsustainable deficit, and the rise in long-end Treasury yields this year reflects those concerns. Higher yields directly increase borrowing costs, potentially slowing economic growth.

Given the political and macroeconomic tail risks under Trump’s presidency, we believe high yield spreads are tight relative to the level of uncertainty. The current complacency among investors presents an opportunity for active managers like us to identify and exploit market mispricings. Today’s high yield market includes segments that we find expensive from a spread perspective and thus less attractive. Conversely, sectors facing negative sentiment, such as energy, offer potential for contrarian trades. The rise in oil prices due to the ongoing Israel-Iran conflict could give a fillip to the sector.

We also see value in the U.S. healthcare sector. Toward the end of last year, regulatory and political concerns triggered a selloff in the sector’s bonds. As political tensions ease, the attractiveness of healthcare bonds could rise. At the same time, CCC-rated bonds and cyclical sectors are likely to be more vulnerable in the event of a sharp economic downturn.

We believe Europe remains compelling relative to the U.S. Investors are highly bullish on U.S. risk markets despite the ongoing trade war. Meanwhile, Europe’s macroeconomic environment is improving, supported by fiscal stimulus and declining interest rates.

Good returns for HY normally come from current yields

Global High Yield Markets: 12 months return distribution when yield to maturity has been between 7% and 8%

Although high yield bond spreads are towards the tight end of historical ranges, the all-in yield remains relatively high, and this coupon income provides the prospect for continued steady returns. Relative to equities, high yield provides advantages such as low duration, seniority in the capital structure, and relatively low volatility. Even so, our guiding principles at this time are “prudence” and “patience”, as investor complacency remains widespread, with many discounting the potential for negative developments.

Credit selection is crucial in this environment. We manage a high-conviction portfolio—typically fewer than 200 companies—and continuously seek bonds that provide an optimal mix of attractive yield for acceptable risk, and alignment with our ESG criteria as an Article 8 strategy. We view credit spreads as compensation for an uncertain future. Thus, we seek a margin of safety when taking on risk—highlighting the need for investment discipline when (as happens periodically) the market becomes more expensive. We have a clear strategy to reposition our holdings and capitalise on volatility whenever such opportunities emerge.

Strategy specific risks

• Share Class Hedging Risk - The share class hedging process can cause the value of investments to fall due to market movements, rebalancing considerations and, in extreme circumstances, default by the counterparty providing the hedging contract.
• Interest Rate Risk - The Strategy can invest in assets whose value is sensitive to changes in interest rates (for example bonds) meaning that the value of these investments may fluctuate significantly with movement in interest rates.e.g. the value of a bond tends to decrease when interest rates rise
• Pricing Risk - Price movements in financial assets mean the value of assets can fall as well as rise, with this risk typically amplified in more volatile market conditions.
• Contingent convertible bonds - The Strategy may invest in contingent convertible bonds. These instruments may experience material losses based on certain trigger events. Specifically these triggers may result in a partial or total loss of value, or the investments may be converted into equity, both of which are likely to entail significant losses.
• Credit Risk - The issuer of a bond or a similar investment within the Strategy may not pay income or repay capital to the Fund when due.
• Derivative risk - the Strategy may use derivatives to reduce costs and/or the overall risk of the Fund (this is also known as Efficient Portfolio Management or "EPM"). Derivatives involve a level of risk, however, for EPM they should not increase the overall riskiness of the Fund.
• Liquidity Risk (general) - During difficult market conditions there may not be enough investors to buy and sell certain investments. This may have an impact on the value of the Strategy.
• Counterparty Default Risk - The risk of losses due to the default of a counterparty on a derivatives contract or a custodian that is safeguarding the Strategy's assets.
• Sub investment grade bonds - The Strategy may invest a significant portion of its assets in securities which are those rated below investment grade by a credit rating agency. They are considered to have a greater risk of loss of capital or failing to meet their income payment obligations than higher rated investment grade bonds.
• Charges from capital - Some or all of the Strategy’s charges are taken from capital. Should there not be sufficient capital growth in the Fund this may cause capital erosion.

Important information

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