Is there a bubble in high yield bonds?

There has been some talk in the media in recent months of a “bubble” forming in the high yield end of the bond market. I thought now would be a good time to evaluate the outlook for high yield bonds going forward and what it means for UK investors.

For those of you who might need a reminder, here is a brief description of how the bond market is structured. In much the same way that the equity markets are divided into large, mid and small-cap stocks, the bond market is broadly divided into investment grade and high yield bonds. As with equities, where large-caps are perceived to be lower risk, but lower return, to their small-cap counterparts, investment grade bonds have lower credit risk, but lower returns (or yield) than high yield bonds.

So what makes a bond be deemed investment grade or high yield? Well, it is determined by the credit ratings agencies, the three biggest being S&P, Moody's and Fitch. Take the example of S&P, where all bonds rated BBB up to AAA are deemed investment grade, and all below are considered high yield. They do this by assessing the credit worthiness of the bond issuer, whether it be a sovereign state, a corporate or a local council. Bond issues rated AAA are considered to be risk free, and hence have the lowest interest rates, and CCC rated bonds have a greater risk of default, and will have rates that are considerably higher.

In recent months, as investors have piled into riskier bonds, in the seemingly endless search for yield, the spread (or perceived difference in risk) between investment grade and high yield bonds has narrowed to nearly all-time lows. If you factor in that investment grade bond yields are being held artificially low by extraordinarily loose monetary policy, in the form of both historically low base rates and quantitative easing, it makes you wonder if investors are really being compensated for the risks they are taking.

For instance, Greece, only two years after the biggest debt re-structuring in history and who at one time was considered the worst of the peripheral European countries, has recently tapped the bond market for €3 billion worth of five-year bonds, at a yield of just 4.95%! Remember that, in 2012, its bonds yielded nearly 50% and, even now, some industry commentators believe it will likely default again in coming years. As one economist put it at a recent conference I attended, if you buy Greek five-year bonds, it's because you think they will default in six!

As a counter argument, you could argue that economic conditions are relatively benign at the moment, companies have deleveraged and are cash rich, and the problem children of the crash, namely the banks, have been subject to so much regulation and capital requirement, that it is going to be a while before investment bankers dream up more exotic products similar to the ones that brought the world to its knees in 2008. In this sense, the high yield part of the bond market has been exactly the right place to be for the last few years, and the good times may well have further to go. The problem is that you don't want to be the last one dancing when the music stops.

So what does this all mean for UK investors? Well, high yield continues to offer competitive yields when compared with other assets classes, which will appeal to income investors. Also, strategic bond fund managers, who focus on total return and have the freedom to move around the credit spectrum, can move away from high yield bonds at the first sign of trouble. Although it is worth noting that if everyone rushes for the door at once, there may not be sufficient liquidity to get out at reasonable prices. Bond fund managers can also buy protection against credit risk, perhaps in the form of credit default swaps, which may insulate some of the portfolio, in the event that the economic environment deteriorates. However, this will not eliminate the risks, and if you factor in that rate rises will also hurt bond prices in coming years, it is hard to have an optimistic view on high yield bonds over the medium to long term. I'm afraid income investors have few attractive options at this moment in time.

By Harry Driscoll, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Harry's views are his own and do not constitute financial advice.