Investors should steer clear of much of the lower quality paper currently being issued in the high yield universe and focus on the higher quality segment of the market, according to Kames Capital.
Global high yield bond funds have hit the ground running in 2017, with strong returns being delivered year-to-date, prompting an increase in issuance from lower-rated companies.
However, Kames is urging investors to avoid the temptations of much of the issuance that has been coming to market recently, highlighting concerns about the quality of some of the issuers and the way they are funding payments to borrowers.
“Global High Yield returns have been very strong since the beginning of the year, but recently we have seen more and more companies taking advantage of the strong market to issue bonds,” says Jack Holmes, investment manager in the high yield team at Kames Capital.
“As is typical in these strong periods, many of these issuers are lower quality – we have had CCC-rated bonds with non-contractual coupons (so the company can choose to pay borrowers with more debt, rather than cash – never a good sign) and bonds funding lending to the riskiest subprime personal borrowers in the UK.”
The trend is being seen globally, with Holmes noting that in the US market CCC-rated bonds have made up more than 20% of total new issuance so far in 2017 – double the rate of last year.
Bonds issued so far this year include CCC-rated packaging company Verallia, which launched a €350m raising that allowed for coupons to be paid for either in cash or more of the bond.
Rather than participate in such raisings, Holmes says Kames’ approach is always to concentrate on the higher-quality part of the market.
“We have found attractive opportunities to buy bonds of higher-quality companies that tend to be overlooked in these risk-on moments,” he says. “These include Quintiles, a best-in-class healthcare information company with 25-year relationships with all of the top pharmaceutical companies; and TalkTalk, the UK telecommunications company with a highly competitive cost structure and strong recurring revenue streams. At times like these we can lend to companies with considerably lower risk for very little sacrifice in terms of yield, allowing us to generate high levels of income with a fraction of the risk.”
Overall Holmes believes the outlook for high yield remains “reasonably strong” this year, although he says Kames will continue to focus on the areas of the market that offer good credit quality as well as compelling returns. “We remain of the view that the best way to achieve attractive long-term returns is by investing in a disciplined fashion in good-quality companies with strong recurring revenue streams. Our approach to the new issuance market has continued this, and we look forward to seeing the results.”