3 min read 25 May 21
In a world of low interest rates and low bond yields, high yield debt markets could potentially have a greater capacity to provide investors with what many of them crave: an attractive income. Achieving such an income stream from their portfolios has become more difficult for investors in recent years, as interest rates remain close to zero, or are even negative in many parts of the market. This has led many to look beyond traditional higher-quality bonds, or bank deposits. High yield debt is one asset class that has become popular.
By focusing on floating rate notes (FRNs) rather than the fixed rate market, investors can insulate themselves from the negative effects that rising bond yields have on the values of fixed rate bonds. Expectations for higher inflation typically push bond yields higher and consequently, prices lower -- and this has been a recent feature in European and US markets. An important question is: what does the market expect? And also: can these expectations change? These two issues will drive the volatility in the fixed rate market. If investors are concerned that this volatility will hurt their fixed income holdings, FRNs may provide a safe harbour from stormy conditions elsewhere in the bond markets. FRN investors could also benefit from increases in interest rates that central banks might impose to dampen inflation, with those higher rates translating into larger interest receipts from their holdings.
High yield markets do carry more risk than investment grade markets, so we believe in taking a relatively conservative approach to floating rate high yield, to help reduce the volatility of the profile of returns for our clients. In addition to taking a cautious stance regarding the more economically sensitive market sectors, we maintain a focus on the senior secured part of the market. These instruments can offer investors some greater protection when, as occasionally happens, issuers default or find themselves in difficulty making payments on their debts. Being secured on assets of the issuer, these bonds have priority over unsecured creditors in recovering debts due.
In our view, the asset class represents an attractive opportunity in a low interest rate and low yield environment. Limited prospects for further declines in yield levels may make fixed rate bond strategies less appealing. High yield debt issuers typically perform well when economic activity is improving, allowing them to more comfortably cover their debt service obligations. As economic recoveries from the COVID-19 pandemic continue, the backdrop for companies is likely to improve. However, we think the market has already priced in much of this good news, so we exercise caution regarding where we are investing.
Our large and experienced credit research team helps us identify the best opportunities in the market, which may include the wider fixed rate high yield market, as it is possible to use derivatives to isolate just the credit element of a bond we seek, while removing unwanted exposure to bond yields. We believe the strategy has the potential to offer investors a well-diversified opportunity to seek to achieve an appealing level of returns in a low interest rate environment. It is insulated from the negative effects that rising yields can have on fixed rate bond strategies, and could actually benefit if interest rates increase.
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The value of the assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.
The views expressed in this document should not be taken as a recommendation, advice or forecast.
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The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.