Last year was the worst on record for some parts of the bond market, but in my view that makes fixed income investing more attractive than it has been in years – though not without some jeopardy, as we will see.

We believe high-yield markets in particular look attractive at today’s prices, especially the secondary markets, where bonds are traded after issuance. You might term these ‘secondhand bonds’.

2022: Impact on bonds

Before exploring that statement further, a quick recap on last year’s tumult may be useful. The ongoing impact of Covid-19, particularly in China, brought friction to supply chains. The war in Ukraine sent gas prices tripling across much of Europe, while electricity prices typically doubled. Both of these issues fuelled soaring inflation, prompting the Fed and other central banks to hike interest rates seriously for the first time in a decade. And all this as quantitative easing was coming to an end.

This prompted repricing across the board – in equities and bonds alike – as markets adjusted to a new reality.

Sterling-denominated investment-grade corporate bonds fell nearly 20% in 2022. Sterling high yield did better but declined nearly 11%, not helped by fears that an energy crisis and central bank interventions might spark a deep recession.

High-yield bonds involve more credit risk, so investors need to be rewarded with higher coupons or yield. This higher yield helps make the asset class less vulnerable to rising interest rates. But it means it is more sensitive to declines in economic growth and corporate earnings. Higher prices, lower consumption and damaged consumer confidence – all factors evident today – increase the risk borrowers will default on loan repayments.

Market sentiment is reflected in the collapse in high-yield issuance. In 2021 – when interest rates and corporate bond yields alike were low – European-currency high-yield issuance totalled a record €150bn gross, while in 2022 it amounted to just €32bn, according to JP Morgan.

Secondary market activity

The secondary market was where much of the action was happening, and that is largely the case today. There has been some recovery since the year started, but many high-yield bonds are still trading well below their 100 issue price – at an average 88.

Because of this, the effective yield of high-yield bonds in Europe on average is 7.3%, according to Bank of America data. At the start of 2022, it was just 3.4%.

This higher yield to maturity is made up of two factors ­– the coupon payments and the assumed capital pick-up as the price of the bond moves to mature at ‘par’.

An example might help illustrate this. Asda issued secured bonds with a relatively low coupon of 4.5% in late 2021, when the market was strong. In November last year we were able to buy those bonds for just below 78p. They are due to mature in February 2026 at 100p.

That implies 22 points of capital appreciation between now and then, as well as the 4.5% coupon Asda must pay bondholders each year. To maturity we are talking about a total return profile of more than 45%, with the benefit of contractual obligations. 

But, of course, recession means there is a heightened risk of defaults generally. Lenders take priority over equity holders when a company goes into administration. The recovery rate for senior unsecured bonds is historically around 40%. The higher default risk nonetheless needs to be taken into account.

Borrowers need to offer terms that are attractive to lenders in the changed interest rate environment. Companies coming to the market today are having to pay much higher costs.

New issuance

Take Verisure, which supplies alarm and security systems. It is based in Europe, where it is an acknowledged leader in its field and boasts around four million customers and is also making inroads in South America.

Verisure came to market in September last year to refinance its 2023 bond, which has a coupon of 3.5%. It managed to do this, yet its new 2027 bond has a coupon of more than 9% – and this is the bond in which we chose to participate.

This means it will pay 9% a year on this bond till 2027. Do you imagine inflation rates will be that high by then? This looks very attractive to us.

Verisure is just one example I could give to indicate a general – and what I think will be a persistent – shift towards a high-yielding environment. This is good news for investors, but they do need to be confident that companies will be able to refinance their debts and cope with higher costs.

There are bargains out there, but the onus remains on investors to shop selectively and wisely. Good credit research and diversification are as essential as ever in mitigating risk and maximising opportunities.

Rhys Davies, portfolio manager of Invesco Bond Income Plus (BIPS ), which mostly invests in high-yielding fixed-interest securities.

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