An income boost from high yield bonds

With low interest rates still looking set to last for many years Rob Morgan considers a distinctive fund investing in high yield bonds.

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  1. Rob Morgan

High yield bonds can play a special role in an investor’s portfolio. They typically offer a high level of income, and are less exposed to the adverse effects of rising interest rates than other fixed income sectors. However, other risks are greater. They invest in companies deemed less creditworthy, and which have a higher chance of bankruptcy or distress resulting in loss of income or capital. They also tend to be more sensitive to economic conditions, as any downturn can result in rising defaults from these more vulnerable businesses.

With the bond market looking increasingly fully priced, the additional yield on offer from high yield bonds compared with investment grade bonds and gilts could be the more dominant factor in returns, which so long as the environment is not too challenging for businesses could see high yield bonds outperform the higher quality parts of the bond market.

To make the most of this area, we believe it is worth employing the services of an experienced fund manager. They should hopefully add extra value by investing in companies whose credit rating they believe is likely to improve – and avoiding companies on a deteriorating trend. In our view, Eric Holt, manager of the Royal London Sterling Extra Yield Bond Fund, is one such individual to consider in this regard, and he casts a wide net in order to find the best opportunities in this diverse sector.

Mr Holt invests predominantly in the UK, but rather than build a portfolio of bonds that have received a credit rating from an agency such as Moody’s, he also invests in “unrated” bonds, which many investors ignore, perceiving them to be higher risk or not worth the effort of investigating. However, many companies choose not to be rated because agencies charge a fee to classify their debt, providing the opportunity for Mr Holt’s team to conduct their own research to uncover bonds they believe are higher quality than widely assumed.

A willingness to look for opportunities in areas where others are reluctant to tread leads to a distinctive portfolio and contributes to a large distribution yield, meaning the fund could be of interest to those wishing to diversify their allocation to fixed income. Unrated bonds account for just over a third of the portfolio and many of these holdings, such as investments in Retail Charity Bonds, are unlikely to be found in mainstream bond funds.

In terms of recent performance, the fund has held up well in recent market volatility. High yield bonds can be affected in a similar way to equities when the economic outlook darkens, but thus far there has only been a minor dip in sympathy with shares. Overall, Mr Holt considers that the current yields available in the space offer adequate compensation for default and other risks.

Recently new purchase activity in the fund has been dominated by participation in new issues including Bracken, the funding vehicle for secured lending group Together, offshore services specialist FSS, HSBC, insurer Prudential and Ziton, the dominant provider of construction and maintenance to the North Sea wind turbine industry. Other purchases included secured bonds of public house business Mitchells & Butlers, banks Santander and Lloyds, and Heathrow.

Sales have included Delamare Finance, bonds backed by Tesco operational property and leases and Aker BP, the North Sea oil company. The fund also booked gains in small, low-yielding holdings of engineering group GKN and PFI infrastructure deal RMPA.

Overall, the fund is fairly well-diversified with over 200 holdings and a top ten accounting for around 19%. Typically, there is low turnover in the portfolio with the manager usually aiming to buy and hold, possibly to redemption when the bond pays back capital.

Our view

The fund currently yields around 5.8% a year (variable, not guaranteed), so for those seeking to boost income from their portfolio, and prepared to accept the associated greater risks, we believe this is an interesting fund run by an experienced and talented manager. It remains part of our Foundation Fundlist of preferred funds across the major sectors.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in collectives should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

 

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