Why high-yield bonds are only for the brave

The US Treasury's plan to help banks to restore their battered balance sheets by encouraging people to buy up to $1 trillion (£690bn) of toxic assets has thrown the spotlight on the potentially lucrative opportunities that are now available to brave investors.

The announcement of the Public-Private Investment Program by the US Treasury Secretary, Timothy Geithner, which will see the purchase of mortgages and securities blamed for the credit crisis, prompted shares to soar on Wall Street.

It also highlighted the handsome rewards for investing in risky companies. Not only can this provide decent long-term capital growth, but also substantially more income than is available through most savings products.

For UK investors, these opportunities are currently on offer within high-yield bonds, which, in effect, sees them loaning their hard-earned cash to firms that have a greater than average chance of defaulting on their debts.

Having been generally overlooked by most investors over the past decade, this asset class has started to grow in popularity, partly due to the staggeringly high yields they have offered since the world plunged into recession last year.

Patrick McCullagh, head of European and UK credit research at Schroders, expects high-yield bonds to be offering more attractive opportunities by the back end of 2009 than the investment-grade corporate bonds that are currently in favour.

"This is not a well-known asset class in the UK, but it's time for investors to start getting acquainted with it because this is where we're going to see some incredible opportunities," he says. "I can see us becoming heavily overweight in this area."

What exactly are high-yield bonds?

They are investments in the debt of companies that are deemed – by a ratings agency such as Standard & Poor's – to have a greater chance of defaulting on their loans, according to Darius McDermott, managing director of Chelsea Financial Services.

"The lower a company's rating, the more likely they are to go bust, but the more investors will be paid for accepting that increased risk," he says. "It means that fund managers who choose wisely can make decent money from this area."

High-yield bonds are particularly attractive at the moment because the credit spreads (the difference between what you can earn on a government bond and a corporate bond) and absolute returns are higher than at any time in living memory, explains Darren Ruane, a bond strategist at Rensburg Sheppards Investment Management.

"There are two main reasons why people are buying high-yield bonds," he says. "The prices have fallen very low recently, while the income yield is high, so people are being paid very well for taking on the risk."

The question from an investor's point of view is whether the return on the bond is enough to compensate for the likely defaults, points out Geoff Penrice, a financial adviser with the firm Bates Investment Services.

"The combination of markets becoming very risk-averse and bank lending drying up means that many fund managers believe that investors are being over-compensated and that the returns could be very attractive over the next couple of years," Penrice says. "The downside would be if the recession turns out to be worse than expected and the level of defaults gets too high."

The best way to play this area of the market is through a fund operating in the IMA High Yield sector. There are about 20 to choose from and, while all will work within the same broad controls, each will have a slightly different way of operating.

Performances also vary enormously. The best performer over the past three months is the JP Morgan Global High Yield Fund, which has made 8.71 per cent, according to Morningstar figures to 23 March. The worst performers, meanwhile, have shed an eye-watering 16 per cent over the same period, so it pays to choose carefully.

The professionals' view

So how are fund managers who are analysing bonds on a daily basis currently treating the high-yield end of the market? The answer is "with caution", according to Kenny Watson, manager of the Ignis High Yield Fund. That is due to technical issues such as hedge-fund redemptions, as well as financial liquidity issues and the deteriorating economic outlook.

The holy grail as far as these stocks are concerned is a company that is likely to be more resilient to the deteriorating economic climate, and with less gearing than would have been considered in the past. "We haven't been doing much buying, but when we have it has been in more resilient names in defensive sectors," Watson says. "These include Wind Communications, an Italian telecom business; and Fresenius, a medical equipment manufacturer."

The next few months, he points out, are likely to prove very challenging. "We expect defaults to rise from their low levels and covenants to be tested as corporate results reflect the more challenging economic conditions," Watson says. "There are attractive yields at present, but these reflect the uncertain outlook."

Robert Cook, manager of the JPM Global High Yield Bond, agrees that there are significant challenges ahead, but maintains that he is able to find significant value by researching a wide variety of sectors.

"We generally look for companies with solid value propositions, either due to superior products and services, or low-cost structures," Cook says. "We maintain a diversified portfolio with holdings in companies from across the economy."

It is also important to take a multi-year view with investments, points out McCullagh at Schroders. "We are steering well clear of companies exposed to the worst parts of the economic cycle, such as chemicals, commodities and auto manufacturing – anywhere, in fact, where consumers can withdraw expenditure on big-ticket items," he explains. "On the other hand, companies producing basic consumer goods within food, drink and telecommunications are likely to survive this recession, which is why we are concentrating our holdings within these areas."

There is certainly potential in this area, but caution pays, according to McDermott at Chelsea Financial Services. He suggests putting in only small amounts – if any at all – over the next few months, with a view to taking a larger position later in the year.

"People are being reasonably well paid for taking the risk, but I probably would not go steaming in right now," he says. "It is better to wait another six months to see what happens to the markets, as you will probably still be able to get the same yield."

It's worth remembering that even if companies default on their debt, bondholders will usually still get something back. This is the difference between investing in equities, where investors will lose everything if a company goes bust.

Recommendations

So where do leading financial advisers recommend that investors wanting exposure to high-yield bonds put their money?

As far as funds in the high yield sector are concerned, Geoff Penrice at Bates Investment Services suggests either the Standard Life Higher Income Fund or the M&G High Yield Corporate Bond Fund.

"Both of these funds are very well diversified and are yielding decent amounts," he says. "When the Bank of England's base rate is so low, it makes them look even more attractive."

Darren Ruane of Rensburg Sheppards Investment Management likes the Legal & General High Income Fund. "This is operating at the more conservative end of the high yield market, which makes sense at the moment," he says.

Meanwhile, Darius McDermott of Chelsea Financial Services agrees with the stance taken by the Legal & General High Income, and suggests that the JP Morgan Global High Yield Fund is also worth a look. "This is at the slightly more aggressive end of the market, but it is well placed to give you the best returns when the market really picks up," he says. "They invest in riskier assets, but the fund has generally performed very well."

Another option, McDermott suggests, are funds in the strategic bond sector, as managers operating in this area of the market have more scope to move in and out of high yield depending on the market conditions.

"Within this area, we like Legal & General Dynamic Bond and the Henderson Strategic Bond," he adds. "The Henderson fund has a good long-term track record, while L&G's is smaller, more nimble, and currently my preferred option."

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