Selective risk/return opportunities remain in High Yield

With a steeper yield curve and expectations of a rapidly improving economic recovery, many strategists are making a case for equities in 2010.

However, whilst the return potential of equities can be greater than that of high-yield bonds, the risks can equally be greater.

F&C's High Yield team is of the view that global GDP growth is likely to remain volatile in 2010, with some experts anticipating the return of shorter, more dramatic business cycles. To prepare for this environment, companies are conserving cash flow and reducing leverage, encouraging tepid growth at best. Slower post-recession growth and lack of earnings visibility, combined with a higher cost of capital, is likely to place pressure on equity valuations and their return potential. Furthermore, the expectation of higher interest rates also supports the case for high yield as the asset class typically performs well amidst rising interest rates, whilst equities have a higher degree of sensitivity in this environment.

As a result, the team believe that better balance sheet management is more supportive of credit and high yield is a particularly "sweet spot", offering investors the opportunity to achieve attractive risk-adjusted returns.   Fatima Luis, who manages the F&C Maximum Income Bond Fund, a specialist high yield fund, commented: "We have taken a number of steps unique to high yield to take advantage of this environment. We moved away from low coupon and high duration issues to mitigate interest rate risk and increased positions in secured bonds at the higher part of the capital structure, giving us access to better quality positions without sacrificing the yield. In addition, we remain overweight in subordinated financials and insurers, which should continue to perform as liquidity and fundamentals improve." 

Luis has also been adding to the US high yield exposure in the fund, currently favouring the US over Europe as macro indicators appear to support a healthier economic picture for the region; they are not entirely out of the woods, however Europe has a longer journey ahead. "Government debt over the next few years is likely to weigh down on growth and economic recovery will be muted as a result. Despite this, the corporate sector has not suffered as much as anticipated at the height of the crisis and in the medium term high yield continues to offer excellent risk/return characteristics," Luis concluded.