Martin added that he fears investors have begun to develop unrealistic expectations of the long-term returns that can be extracted from bonds without taking excessive risk.
Speaking at the same event, Willis Towers Watson senior investment consultant Kate Hollis agreed, warning investors to be careful about reaching too far for yield, particularly in private markets.
“You have so much less transparency on what’s going on and you could have a strategy which does beautifully for a couple of years and then suddenly blows up, because the fund manager is taking on too much money and reaching too far to allocate the capital,” she said.
Is this just hearsay or are investors and asset managers actually pushing this search for yield too far? And in doing so, are they creeping back into old habits last seen in the build-up to the financial crisis?
BE AWARE OF LOW QUALITY
There is no doubt investors are chasing higher yielding assets. The Bloomberg Global High Yield Corporate Bond index has returned 13.56% over one year and the strength of the bond market since the start of the year (see chart inset) has led to a flurry of new issues from companies looking to raise capital.
But Kames Capital has observed that these issues have moved down the credit quality curve as strong returns have led to lower-rated companies issuing securities. In the US market more than 20% of total new bond issuance in 2017 has been triple-C – double the rate of last year.
The asset manager warns investors to avoid the lure of these issues. This is not just because of the low credit quality, but also due to concern over the way some of these issuers are funding payments to borrowers. One example is French glass packaging company Verallia which in February issued a €350m (£303m) triple-C bond that allowed coupons to be paid for in either cash or more of the bond.
Kames Capital investment manager in the high yield team Jack Holmes says: “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.”
Similarly, M&G Investments head of portfolio management David Lloyd observes as markets have become more expensive investors have been forced to take on more risk to achieve a particular target return. This behaviour, he adds, has led to an increase in investors entering the market seeking to pick up a yield, known as high yield tourists.
“It is not necessarily taking risk per se,” he says, “but it is taking risk you are not familiar with or not properly equipped to analyse and make a judgement on.” This, he warns, is something that “never ends well”.
INCREASED LEVERAGE
These warnings chime with other parts of the industry. According to Cambridge Associates managing director Himanshu Chaturvedi, leverage has crept up in parts of the market, particularly in corporate balance sheets, as a consequence of investors reaching for yield attracted by the floating rate nature of these loans.
“There are investment products out there that have more leverage than we think,” he adds. “In the fixed income space we are seeing loans on loans; strategies that lend money and are then being levered up. The fact that these are in the market can be a warning sign, especially when you start to see these systematically popping up.”
Chaturvedi is not alone in this observation. Research by consultancy bfinance has noted leverage, and therefore risk, increasing in senior direct lending funds. It also found unitranche loans – those that combine senior and subordinated debt into one debt instrument – have gradually become more dominant in the senior portion as managers try to keep internal rate of return expectations on track despite spread compression.
