The surge in bond yields as inflationary pressures pushed central banks to move interest rates sharply higher has created an opportunity for investors.

Just how generous is this income stream though and how do the potential returns from investing in bonds and credit compare with cash? Or put more simply, what sort of returns can you expect from fixed income?

THE IMPACT OF HIGHER INTEREST RATES

Bonds offer a higher yield when their prices fall and they have an inverse relationship with rates – meaning prices go down when rates go up.

Because many bonds require minimum investment levels running into the tens of thousands of pounds, investors often use funds to gain access to this asset class.

According to FE Analytics data the 228 open-ended bond funds available to retail investors offer an average historic yield of just 2.4%, well short of the levels of interest available from cash on deposit and current levels of inflation.

Investment trusts are better placed to put money into less liquid and more niche investments to generate higher levels of yield. This is because they don’t need to sell assets to meet redemptions when investors want to exit.

The average yield from the relevant AIC Debt: Loans & Bonds sector, a universe of 10 names, is a much healthier 7.6%.

This makes it an interesting area to explore for income investors, particularly as there is also scope for capital appreciation too, assuming bond prices start to recover. However, you need to be aware of the hazards which come with these higher yields.

INVESTING TO ACHIEVE HIGH LEVELS OF YIELD

The manager of Invesco Bond Income Plus (BIPS) Rhys Davies explains the investment process behind his trust. He says: ‘Myself and the board will agree on a dividend target in pence per share – that is currently 11.5p. That’s a figure which I think is achievable without taking too much risk.’

The share price is currently 164p so the implied yield is 7%.

Davies says the portfolio is put together with this dividend target in mind by investing in the higher yielding parts of the bond markets.

This includes traditional high yield corporate bonds – what the trust calls income generators – which form the core of the portfolio.

On top the trust invests in subordinated debt (ranking lower in the list of creditors than other types of credit) from European banks and financials (an area which has been hit by the collapse of Credit Suisse and tangentially by the US banking crisis).

It also invests in bonds which have come under price pressure but where there are plans afoot to turn around the business and its balance sheet, although this is only a small part of the portfolio.

The trust was enlarged by its merger with Invesco Enhanced Income in 2021 and Davies, who steers the vehicle along with Edward Craven, has been in place since 2014. He observes that since the financial crisis there have been windows of opportunity when it has been possible to lock in high yields, but these have tended to be very brief – citing the period after the Brexit vote and the initial stages of the Covid pandemic.

Discussing the impact that the sharp rise in interest rates has had on bonds, Davies says: ‘We’ve now got a much larger window of opportunity and it is still there. I do think we have shifted into a high yield environment for the foreseeable future. The coupons we’re being paid on new issuance are two or three times the level of coupon at the height of the market back in 2021.’

Davies gives the example of BT which came to the market with what’s called a corporate hybrid (its most junior piece of debt) paying an 8.375% coupon for five years. According to the Invesco manager, the same sort of debt would have cost the company half that level of coupon two years ago.

Investment grade bonds versus high yield bonds 

Investment grade refers to the highest quality part of the bond market and these issuers have stronger balance sheets which should make them more resilient in an economic downturn.

High yield corporate bonds are the riskiest part of the bond market because they are considered the most likely to default during economic downturns.

Investors may not get their capital back in full when this happens.

UNDERSTANDING THE DEFAULT RISKS

Higher yields are usually accompanied by a potentially higher risk of default – i.e., a company being unable to pay its debts. Erik Knutzen, chief investment officer of the multi-asset team at Neuberger Berman, observes: ‘We are looking out for cracks in the credit market as the high-yield maturity wall comes ever closer and the first policy rate cuts get priced further and further out, raising the threat of expensive refinancings.

‘This is perhaps the most visible threat, and therefore one we think could be priced in sooner rather than later—a “canary in the coalmine” warning of broader market volatility.’

For his part Davies acknowledges the risks. He comments: ‘Companies which are able to come to the market and issue bonds with these higher coupons are generally in a position where they can afford to do that. The market wouldn’t lend to them if they didn’t think that. They create very exciting opportunities for us.

‘Where we need to be focused at the moment is in the secondary market, where bonds may be offering a much better level of yield than when they were issued. We need to be thinking about the future credit risk of that company. If we have doubts, we have already started the process of removing them from the portfolios.’

Davies notes the maturity profile of the market is a good indicator for when companies are likely to have to roll over to higher levels of debt. ‘Right now, we are looking at late 2024, early 2025 when a “wall of maturities” comes through – so in a year’s time the market will really have to start thinking about it,’ he adds.

Fixed income fund managers can mitigate credit risk through diversification – Invesco Bond Income Plus has exposure to 170 different issuers, for example.

Including the coupon and the capital upside Davies believes a high single-digit return from the high yield market is possible. ‘I’m enthusiastic and excited about the outlook for credit because of the types of yields available today which were last available when I first started 20 years ago, but we do need to manage our way through the credit risks.’

WHAT HAS CVC INCOME & GROWTH BEEN DOING RIGHT?

Among the best performers over the last 12 months in the AIC Debt: Loans & Bonds category is CVC Income & Growth (CVCG).

Manager Pieter Staelens says: ‘The strategy was started in 2009 off the back of the financial crisis – we mainly invest in leveraged loans which is the big difference between us and other credit investment trusts which invest in high yield bonds.’

This market does not have a fixed rate of interest but a floating coupon which changes every three months or so to reflect the interest rates set by central banks. 

Leveraged loans tend to be secured in nature, or in other words backed by the issuers’ assets, which is not always the case with bonds.

Staelens says: ‘It’s a little bit like a mortgage on a house. If I lose my job and I can’t pay the interest on my mortgage anymore then the bank will repossess my house and sell it, and if my loan to value is 50% the bank probably won’t lose too much money on it. Unsecured bonds are more like credit card debt where yes, I promise to pay you back but the bank doesn’t have security over any of my assets.

‘In an environment where companies are struggling with the higher cost of financing, we would expect default rates to go up. But if you have higher default rates and you get some good recovery on these loans, default rates don’t hurt as much as if you were to invest in unsecured debt.’

Staelens observes the average default level over the last five years has been around 1% with recovery rates for senior secured loans at 60 to 70 cents on the dollar.

‘During the great financial crisis default rates peaked at 10%. Even at those levels if you assume the 60 to 70 cents recovery rate still holds, you’re looking at a loss rate of 3% but we’re getting paid 9% so it’s still a very attractive opportunity and we’re nowhere near great financial crisis kind of conditions,’ he says.

FOCUSED ON LARGER COMPANIES

Staelens says CVC Income & Growth principally lends to large companies and not small and medium-sized firms which are more at risk of default.

While there have been some examples where recovery rates have come in lower than average thanks to looser credit agreements struck when market conditions were more favourable for borrowers, the trust stays away from such loans.

CVC Income & Growth also benefits from a large team of analysts which do a lot of work when deciding which businesses to lend to – Staelens says this capacity is really important in a tougher economic environment where the rate of defaults is higher.

One downside compared with high yield bonds is if central banks start to cut base rates. In this situation floating rate debt might compare unfavourably with the elevated levels of fixed income currently available on corporate bonds.

However, Staelens argues there is potentially a place for both in a broad portfolio and notes the trust itself holds some high yield bonds.

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