“I always sell too soon” – investing in high-yield bonds

When asked how he’d made his fortune, Nathan Rothschild, one of history’s most famous investors said; “I never invest at the bottom, and I always sell too soon.” His modest reply could have meant that he was less likely to focus time on the market highs and lows, and more inclined to watch the general trends.

Making the most of markets rising and falling is an interesting challenge for all investors, whether
institutional or personal. We all spend a lot of time researching investment opportunities, trying to identify the asset classes that are appealing in price and that can spread the risk within our existing portfolios. But do we spend the same time watching the trends and working out when we should take profit from our successful investments?
 
Moving into high-yield bonds  
As an example of this, take the move by defined benefit pension schemes into high-yield bonds. High-yield bonds are generally those rated below investment grade. They are riskier, but as a result, and as the name suggests, pay a higher yield.
 
To date, the move towards high-yield bonds has pretty much played out exactly as intended. Since the dark days of 2009, high-yield bonds have been improving in price as more and more investors have used them to diversify their growth asset portfolio. Since quantitative easing (QE) began, and especially during 2012, this aggressive price action has been further accentuated as alternative fixed income investments with lucrative yields became notably less available – in many ways the primary purpose of QE.

I have heard a number of commentators voice their concerns in recent months about the long lasting nature of these high prices and the potential for associated early selling. But there’s been no
meaningful reduction in new funds investing in this class, and as of yet no major sell-offs.
 
I’d suggest that investors might begin to question whether there could be a chance of growth assets being re-priced especially with signs of the US withdrawing from their QE programme. A reduction or an unwinding of QE is likely to lead to a large increase in interest rates and while the future direction for UK rates in the medium-term isn’t as clear, the valuation of high-yield bonds is influenced by what happens in the US.

If you’ve had a strong performance from high-yield bonds over the past few years, it might be the
right time for you to take profit and reinvest the proceeds. Your options could be to look at more traditional growth, whose return is likely to improve as the economy recovers, or a defensive asset class to preserve the gains you’ve had to date.
 
The net effect 
Pension schemes can afford to be relatively sanguine about falling bond prices where the cash flow from these bonds is being used to match expected liabilities, as the liabilities will show a corresponding fall in value. But where the assets are in the return-seeking bracket, like high-yield bonds for example, any reduction in value is far more concerning as it won’t necessarily be mirrored by falls in the liability calculations.

There are two other factors that could make selling any high-yield bonds timely:
 
 • The scarcity argument will be less valid as the expected yields on other asset classes return
to more attractive levels.
 • In contrast to equity type investments, any economic recovery won’t change the expected cash
flows from this asset class. So, just at the time that this asset class sellsoff, equity could become more appealing.
 
Taking the next step 
To a certain extent it could be argued that high-yield bonds have done the job they were bought for - they’ve performed well, probably above expectations, at a time when equities haven’t performed so strongly. But given the potential downside, particularly as QE gets unwound, now may be a good time to bank the gain taken to date.
 
Certainly if we look at Nathan Rothschild, a little regret risk at selling too soon doesn’t seem to have done him too much harm.
 
Nicholas Secrett is a director in our Pensions team. You can contact him on 020 7213 3340
or by email at [email protected]
 
This information has been prepared for general guidance on matters of interest only, and does not
constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice.

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