A bird’s eye view of credit markets

With UK interest rates now at post-financial-crisis highs, and inflation falling over the last year, fixed income assets are again offering attractive levels of prospective returns, even after taking into account the effects of inflation. Against this backdrop, corporate bond funds are naturally of interest for investors looking to generate additional income to that available on government bonds, money market funds and deposit accounts.

So, how should investors assess their options across credit markets? Is this the time for high yield funds? Or are investors better off with investment grade?

Well, as ever, the prospective return profile of any corporate bond fund relies on two risk factors, interest rate risk (duration) and credit risk.

Investment grade bond funds typically have higher levels of duration relative to high yield bond funds, as their higher-quality companies can issue their debt over a longer time period. This means that the price of their bonds is more sensitive to movements in interest rates, as, when interest rates rise, the future schedule of income payments on existing bonds becomes less attractive resulting in a fall in the price of their bonds, and vice versa as interest rates fall. High yield funds, by contrast, invest in bonds of companies that typically issue over shorter time periods, as their longer-term prospects are less clear to lenders. Movements in interest rates therefore have less of an impact on the return profile of high yield funds.

Credit risk, however, is naturally higher in high yield funds, as these lower-quality companies are more likely to renege on their repayment schedules. This higher credit, or default, risk necessitates a higher premium for lending to these companies, hence the label ‘high yield’.

The structural benefit of holding high yield bond funds over investment grade is therefore the lower duration and higher yield on offer, whilst the structural drawback is the higher default risk, and therefore potential for greater volatility and losses.

Within the current macro environment, if the economy remains stable, interest rates hold and corporate defaults remain low, then high yield bond funds will almost certainly continue to outperform investment grade bonds. However, should interest rate expectations fall and recession concerns rise, high yield bonds should struggle, and investment grade bonds outperform.

Within some of our portfolios (risk profiles 1-4) we reduced our high yield exposure early in 2024, after having a relatively high allocation throughout 2023. This followed a number of years where it had been the strongest performing area within fixed-income markets, given its low duration and higher credit risk profile. Essentially at this point we felt valuations had become somewhat tight in the market and that they no longer offered the relative value they once did versus other areas of the fixed-income universe, particularly if developed market economies were to struggle under higher interest rates. Meanwhile, whilst not enamoured by valuations within investment grade credit, we do continue to prefer it for the resilience that higher-quality bond issuers typically have in economic downturns, alongside its higher exposure to interest rate risk at a time when interest rates are potentially at the zenith of their cycle. We continue to hold high yield for these portfolios and short of a large move in valuations, we are unlikely to make changes to the allocation in the coming quarters.

For higher-risk portfolios that carry a narrower selection of fixed income (risk profiles 5 and 6) we left the allocation to high yield unchanged as we feel its overall yield retains the ability to provide an ‘equity-like’ return with lower volatility.

Two active funds we like to use to access the credit markets are the Artemis Corporate Bond and the Invesco High Yield funds.

Well-known bond investor Stephen Snowden and his team have done a fantastic job since the 2019 launch of the Artemis Corporate Bond fund, consistently delivering outperformance for investors from both a sector allocation and security selection perspective. The fund is typically run with more risk than its index, with the risk allocation fluctuating between interest rate and credit risk depending on the team’s views. That said, the managers are committed to keeping the fund’s duration within a fairly narrow band (1.5 years) of that of the index. This ensures the fund’s return profile remains equivalent to that of wider fixed-income markets.

Meanwhile, Tom Moore invests his Invesco High Yield fund across a combination of high yield bonds that are more highly rated, sectors such as financials and more special situations.

Given the volatility of the latter two components, the fund is typically at the more volatile side of its market. Moore’s positioning in financials has been particularly additive to relative returns over the years, and he continues to see good opportunities in the sector.

 

 

The value of investments can go down as well as up and your client may not get back their original investment.

Past performance is not a guide to future performance and some investments need to be held for the long term.