Stagflation or deflation could potentially be a risk for high-yield bond markets. At present, this risk would seem to be more focused on eurozone markets. Another possible risk is a normalisation in yield curves, which could result in a back-up in spreads – arguably this is more relevant to the US market.
Liquidity-related price volatility in credit markets could be a further risk factor, although it remains to be seen to what extent broader equity markets remain unaffected by such a scenario.
I believe interest rate movement will be the key performance determinant in the coming years, as opposed to the emergence of any credit issues. In my opinion, company fundamentals remain strong, defaults will remain low and interest rate coverage high due to the low cost of debt refinancing. The more likely scenario is for rates to remain low and/or increase steadily. However, it is the market reaction to such a backdrop that is key, in particular perceptions on how fast and far rates might move. As a result, we would expect to see increased volatility around data releases from the US Federal Reserve and other central bank statements. This could create buying opportunities, given that the investor base is already long credit. Consequently, it may be prudent to retain some portfolio liquidity against any allocation to the asset class.
In summary, it is important to manage investor return expectations for high-yield bonds. The upside for credit to perform on a total return basis is limited, in my view, and strong nominal and real returns from this point are arguably unlikely in anything other than a 1990s Japan-style scenario. However, while it is less attractive than in previous years, I do not consider the high-yield bond market to be in bubble territory. It would, however, be prudent to hold back some liquidity to take advantage of any pullback in prices, focus more on US high-yield bonds and resist the temptation to over-reach for yield in more illiquid markets at this stage of the cycle.
Gareth Lewis is chief investment officer of Bestinvest
Many investors and asset allocators have taken on more credit risk through increased exposure to high-yield bonds
Credit quality on new high-yield bond issuance has clearly been deteriorating in recent years
