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Why high yield remains a lunar-tic trade

There's a Christmas TV ad for U.K. department store John Lewis that's proving very popular at the moment. In it a young girl sends a telescope to a lonely old man living on the Moon.

That old guy was once a bond fund manager in 1994.

Our unfortunate lunar friend was banished after the bond market tanked in the 1990s. The U.S. Federal Reserve decided to hike rates and he wasn't ready; he was catapulted to obscurity as yields ballooned. Now, using his telescope he can look back at Earth to see what's become of his old haunt. And just like the young girl in the ad, many bond managers will be looking back at him, more nervously than sympathetically, as they try to glean lessons from the past.

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Tim Bradley | Getty Images

Back in 1994, the U.S. Federal Reserve wrong-footed the markets with several quick interest rate hikes. Many bond fund managers lost their shirts in that debacle.

This time around, there is no excuse for poor positioning. The increase in interest rates has been flagged for some time – the problems with high-yield debt equally so. Despite that, slumping oil prices and rising benchmark interest rates are likely to squeeze many investors in the coming months.

Cracks are already beginning to show in high-yield markets as large investors finally shoot for the door. Several large US high-yield bond funds have seized up due to poor liquidity and more could follow.

We haven't liked high-yield debt for some time. There are many reasons for this stance, but the pivotal one is the price of risk. The risks we take differ, but each has a price. At the moment, the market does not offer enough return to offset the default risks, in my view.

Further, the high-yield market has fundamentally changed. It is mostly low-quality bonds with the loosest covenant protections I've ever seen. In trying to solve the "too big to fail" dilemma of modern banking, regulators have opened the floodgates for a massive issuance of additional tier one capital and hybrids that are categorized as high yield.

If the company gets into trouble, coupons for this low-quality paper can be suspended or cancelled, and capital exchanged for equity or written down to zero. This kind of quasi-debt has swelled five-fold in Europe to almost 100 billion euros in the past three and a half years. This risk is being sold in monumental quantities by the banks. High yield spreads are much too thin to compensate for the risks these instruments carry.

I believe the altered make-up of the high-yield market could make estimates for defaults (and the amounts recovered in such circumstances) far too optimistic. That has spread to non-financials too: last month Vodafone dropped a US 30-year issue because it tried to push too far on the covenant-lite trend.

Another menace for bondholders is the current spate of mergers and acquisitions. These deals, usually financial engineering to boost equity returns, are invariably paid for with more debt. Bond fund managers are simple people: we like to get a decent coupon and get our money back at the end. M&A usually weakens balance sheets as well as our chances of recouping our cash.

Because of these reasons, I am not swayed by most fixed-income opportunities apart from investment grade bonds. However, as I said before, the game is pricing risk. At some point the risk in high-yield markets will be undervalued by the market, making it a fantastic buying opportunity. For now I prefer to wait for the post-Christmas sales (after the Fed hikes its rates) – there could be much better value elsewhere by then.

Bryn Jones is head of fixed income research at Rathbones. His views are his own and are not to be taken as investment advice.

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