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Is there still value in the high yield bond sector?

Michael Scott is the dynamic manager of the Schroders High Yield Opportunities Fund which invests in fixed and floating rate securities worldwide. He has managed the fund since 2012 and has established an enviable performance record. Sue Whitbread caught up with him to talk about his high conviction approach which is based on in-depth credit research and how he is making the most of opportunities in the current market environment


SW: Can you talk us through your investment approach to management of the High Yield Opportunities fund? What are the fund’s objectives?

MS: We designed the High Yield Opportunities fund to focus on providing a very solid return, whether clients are looking to grow their capital in a diversified portfolio or seeking regular sustainable distributions. The investment outcome for our clients is the main priority, so we believe a flexible strategy is of key importance, whether a fund is benchmarked or unconstrained. Flexibility allows us to take advantage of opportunities where they arise and to improve diversification. To deliver strong returns, we believe that you have to go the extra mile. You have to dig down into the market to discover value at the issuer level rather than relying on the market or sectors of the market to do it for you. While economic growth is a major influence on the performance of companies, there are a lot of other things happening in the world that can play a pivotal role in their future outlook. Take the retail sector, for example. Strong global growth provides a positive footing, but any retailer that fails to adapt their business model to take advantage of the rapid development of on-line retail is likely get into trouble. Demographic changes are another factor that businesses must contend with.

If a company fails to target its products at the right group, it can fail, irrespective of its size. So, our approach is to try and understand how the world is changing and to work out which companies are at risk and which are undervalued by the market. I think this is a very risk-balanced approach.

SW: Do you have a set yield target for the fund or is it flexible?

MS: We haven’t set a target yield but work hard to ensure that investors receive an attractive income stream as part of their total return. We believe that this fund is very capable of generating above 6% per annum over the cycle. Given that, it’s important to remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

SW: Where are you seeing the best opportunities for growth in the high yield bond sector currently? Could you briefly explain the reasons why?

MS: The current economic environment is undoubtedly positive for the market, when viewed from above. There has been a synchronised uptick in growth and defaults are low which is great for credit. However, a lot of this good news is already fairly reflected in price so if you focus on the market in aggregate, as many observers do, it can be difficult to see much compelling value. The problem with observing from above is that you don’t see what’s going on within.

It may surprise some people, but we really like the UK market. Brexit has put a lot of people off the UK market, which has cheapened a lot, especially when compared with the Eurozone. This means that we’re finding plenty of bonds from good UK issuers with well-managed business models trading at attractive valuations. We also see value is in some euro-denominated, B rated issuers. This market experienced about of volatility towards the end of last year that opened up some value. Some Latin American markets have also become a fertile hunting ground. In Brazil for example, the bond market is seeing the benefit of a marked improvement in economic fundamentals over the past few years from a very low base. Unemployment has improved, inflation is under control and as a result interest rates are falling. Let me stress, however, that in all of these areas, the right security selection is important.

SW: How do you capitalise on those opportunities in the fund whilst minimising the default risk?

MS: It’s very important to maintain diversification. This doesn’t just mean having a lot of bonds; if they are all sensitive to the same risks then you are not diversified. When I talk of diversification, I mean in terms of strategy. We start by identifying around 10-20 different themes that we think will play out over various horizons but will have a meaningful impact on corporate fundamentals in a forward-looking way. These themes give us a very useful starting point. Then we really drill down to understand how these themes could impact each issuer’s ability to meet their debt obligations. As investors, we should be taking a forward-looking view and our themes provide a framework for that.

SW: Where do you see the main downside risks to performance at the moment and how do you mitigate those?

MS: While volatility in general was extremely low through much of last year, it’s prudent to expect this to normalise in 2018. With aggregate valuations across all risk assets priced to reflect a very positive outlook, this is likely to lead to bouts of periodic short-term negative returns as investors shuffle asset allocations to try and time market movements. Funds which have the flexibility to diversify, which look for opportunities globally, and which have managers who specialise in bottom-up selection, should shine in this environment.

SW: What are your main constraints on the fund? Is it constrained by a benchmark for example or do you prefer to have full flexibility around investment choice?

MS: The main constraints are set by the Investment Association (IA) sector definitions, such as holding at least 80% in High Yield, but we also allow up to 50% in US dollar denominated bonds where we hedge the currency back to Sterling. We don’t manage the fund against a benchmark because doing that would tie the fund’s return to that benchmark, give or take relative outperformance. Instead, we think that having more flexibility is aligned with the return needs of clients.

SW: Looking ahead, with concerns over interest rate rises, what’s your view on the outlook for high yield bonds in general and also for your fund?

MS: Our expectations that volatility would rise from extreme lows and potentially present investment opportunities have played out, at least to some extent, in the early part of the year to date. One notable shift in February was a move higher in expectations for 2018 US rate hikes. Expectations for 2018 hikes now look more realistic, but there may still be bumps along the way.

The volatility-induced widening of spreads was not dramatic and does not, in our view, constitute a decisive reset in market dynamics. The initial spark for volatility seemed to be an upside surprise in hourly US wage growth. Moderately rising inflation is consistent with economic fundamentals and there is a way to go before inflation becomes problematic. We remain constructive, both on a top-down and bottomup perspective, and actively seeking attractively-valued opportunities.

The broad and synchronised cyclical upswing in the global economy continues to provide a good backdrop for credit fundamentals. Europe may be near the cycle peak with valuations reflecting the positives. Certain parts of high yield appear attractive. By comparison, the US cycle may extend beyond 2018 on fiscal loosening so monitoring inflation remains crucial.

The withdrawal of ultra-accommodative monetary policy will continue gradually, but the market will remain sensitive to any perceived shift in tone from central banks. The new Chair of the Federal Reserve, Jerome Powell, seems marginally more bullish and therefore hawkish than his predecessor, Janet Yellen. Rates, and yields, are likely to rise gradually which, on balance, should be welcomed by credit investors.

We continue to watch the rise in leverage in the loans market, which can indicate a late stage in the credit cycle. We will look out for increased mergers and acquisition (M&A) activity too whilst remaining vigilant about political risk. The challenges and concerns over Brexit seem set to persist and continue to result in attractive valuations in good quality UK issuers.

In-depth credit research is key to identifying value. The importance of high conviction security selection becomes ever more visible when aggregate spreads are low. In the current environment the ability to differentiate between issuers provided by Schroders’ research capability is likely to play an increasingly important role in generating returns and managing risk. The challenges and concerns over Brexit seem set to persist and continue to result in attractive valuations in good quality UK issuers

6m

1y

2y

3y

Fund 2.9% 7.3% 25% 46.5%
Sector 0.7% 3.6% 12.8% 23.8%
Quartile 1 1 1 1
Q4 – Q4 2017 2016 2015 2014 2013
Fund 9.9% 11.4% 5.0% 5.0% 8.3%
Sector 6.1% 10.1% -0.7% 1.2% 7.0%
Quartile 1 2 1 1 1</td?>

Source: Financial Express bid to bid net income reinvested as at 28
February 2018. Source for ratings Citywire, Fund Calibre, Morningstar,
Rayner Spencer Mills, Financial Express as at 31 January 2018

In difficult market conditions, the fund may not be able to sell a security for full value or at all. This could affect performance and could cause the fund to defer or suspend redemptions of its shares

Risk factors

  • The fund can be exposed to different currencies. Changes in foreign exchange rates could create losses.
  • High yield bonds (normally lower rated or unrated) generally carry greater market, credit and liquidity risk.
  • A rise in interest rates generally causes bond prices to fall.
  • A decline in the financial health of an issuer could cause the value of its bonds to fall or become worthless.
  • A failure of a deposit institution or an issuer of a money market instrument could create losses.
  • In difficult market conditions, the fund may not be able to sell a security for full value or at all. This could affect performance and could cause the fund to defer or suspend redemptions of its shares.
  • Failures at service providers could lead to disruptions of fund operations or losses.
  • Mortgage or asset backed securities may not receive in full the amounts owed to them by underlying borrowers.
  • The counterparty to a derivative or other contractual agreement or synthetic financial product could become unable to honour its commitments to the fund, potentially creating a partial or total loss for the fund.
  • A derivative may not perform as expected, and may create losses greater than the cost of the derivative.
  • When interest rates are very low or negative, the fund’s yield may be zero or negative, and you may not get back all of your investment.
  • The fund uses derivatives for leverage, which makes it more sensitive to certain market or interest rate movements and may cause above average volatility and risk of loss.

Michael Scott – Credit Fund Manager
Michael Scott is a Credit Fund Manager at Schroders. He has been managing funds since 2012. Michael joined Schroders in 2006 as a European Industrials Credit Analyst. Prior to Schroders Michael worked at Cazenove Capital Management.
Qualifications:
BA (Hons) in Geography from Oxford University.
CFA Charterholder

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