Riskier high-yield debt draws attention

Investors who fear that the seven-month rally in investment-grade corporate bonds may be over are now moving their money into riskier high-yield bond funds, according to advisers.

With the Bank of England base rate unchanged at 0.5 per cent, the average 6 per cent annual yield (before tax) from investment-grade bonds still looks attractive compared with cash deposit rates. It is also well above the 3.7 per cent provided by 10-year UK gilts.

But the ongoing demand for corporate bonds is pushing prices up and yields down – limiting scope for future capital growth.

Figures from the Investment Management Association (IMA) show that corporate bond funds were the best- selling fund sector for 10 consecutive months to August.

So investors willing to bear the risk of buying into lower-quality debt are now migrating to the high-yield market, eager to earn yields as high as 11 per cent as well as the potential for capital gains.

“Investors who are looking for higher yields are starting to go up the risk curve,” says Patrick Gordon, a market strategist with Killik & Co, the advisers.

“I think we’ve seen the best of the rally in the corporate bond market, but that’s not to say corporate bonds won’t make further progress in a low interest rate environment.”

Paul Read and his fellow fund managers at Invesco Perpetual say bank debt offers value now, while the bonds of utilities and telecom companies are trading at fair value. Raphael Robelin, a portfolio manager with BlueBay Asset Management, is also a fan of the subordinated debt of financial companies, but he is hedging his bets in some cases by buying credit protection.

Adam Cordery, a bond fund manager with Schroders, expects that interest in corporate high-yield bonds – which are largely denominated in euros and therefore carry additional currency risk – will rise in the fourth quarter and they will remain popular in 2010.

However, more cautious investors may want to bypass the high-yield market, as advisers warn that more companies in this sector are likely to miss their interest payments or even fail if the downturn is prolonged.

Ben Bennett, a credit strategist with Legal & General, warns that any further economic troubles would damp demand: “The recent ‘dash for trash’ has pushed valuations to a level that provides little buffer against a further economic setback,” he wrote in a note to investors.

“If things take a turn for the worse in 2010, demand for high-yielding assets could dry up as quickly as it appeared.”

Cordery believes that investors with cash are still likely to put it into investment-grade bonds to start with. “The conclusion I’ve come to is that people get nervous about diving straight into high-yield bonds – they want to take an immediate step first,” he says.

At present, the market for sterling-based investment- grade bonds is valued at £330bn, according to Cordery’s calculations, while the European high-yield bond market is far smaller at €115m (£102m).

So far, both markets have been supported by a combination of low interest rates, a wide spread between the yields on corporate bonds and gilts, and the improving performance of cyclical companies.

John Stopford, co-head of fixed income with Investec Asset Management, predicts that financial bonds and cyclical industrial bonds rated from BBB to B will continue to outperform in the coming months.