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James Gledhill
The higher yielding sub-investment grade sector proved particularly resilient in the second quarter of 2006 as financial markets in general suffered.
High yield bonds have proved robust because the corporate environment has been relatively benign, with strong global economic growth keeping company earnings buoyant. In the first quarter of 2006, US corporate profits as a percentage of gross domestic product reached 12.2%, the highest figure since 1966.
Cash flows have been strong and there is little to suggest that coupon payments are in jeopardy given that the outlook for global economic growth is relatively favourable. In such an environment, default rates among high yield bonds have remained historically low. Default rates may begin to climb as the economic environment becomes more challenging but they are starting from a low base. While some moderation in US economic growth is expected, it is difficult to envisage a severe growth slowdown globally in the short term given that many economic indicators remain firmly positive.
With default rates low, the extra income produced by high yield corporate bonds has contributed to their outperformance relative to investment grade bonds. Outperformance has also been generated by the fact that ‘event’ risk has proved more favourable for the high yield market. A pick-up in merger and acquisition activity has resulted in many acquirers tapping bond markets to finance their deals. This has had a negative impact on investment grade credit ratings. By contrast, corporate activity is often less negative for high yield issuers since credit ratings can improve when such companies are taken over by stronger entities.
Interest rate risk is clearly a concern but there does not appear to have been a step-change in inflation expectations, despite recent nervousness. While commodity prices have risen, consumers still appear price sensitive and wage growth remains fairly constrained. The US Federal Reserve has probably not yet finished its current round of monetary tightening. Given this mildly hawkish environment, it is therefore difficult to get overly excited about sovereign debt. The pick up in government bond yields since the start of the year does mean that short-dated gilts are beginning to look better value and could benefit if equity markets weaken further. In the absence of the economy keeling over, however, high yield corporate bonds continue to look the most attractive area, although with spreads quite narrow returns are likely to be primarily driven by income.
James Gledhill is Fund Manager of the New Star Euro High Yield Bond Fund
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