High-yield bonds no longer compensate for risk Wealth managers are urging investors to be careful when considering investment in high-yield corporate bonds, amid fears that a bubble is building in global bond markets. Sales of high-yield bonds, known in the US as junk bonds, have increased as low interest rates force investors to look at increasingly risky asset classes for inflation-beating returns. But according to some advisers the yields on offer in this sector are no longer compensating investors for the risks involved. A report from S&P Capital IQ in March found that, on average, yields from European high-yield debt have fallen by 5 per cent over the past year. At the same time issuance volumes are booming and by its calculation the risks of default have doubled. Yet investors appear to be unperturbed. The problem, according to Tom Becket, chief investment officer at PSigma Investment Management, is that investors looking for income have few options left. Investors are being told to expect annual returns of 5.5 per cent or 6.5 per cent, which look good compared to the alternatives. "Global investors have found themselves in a situation where first cash rates were unattractive, then government bonds, then investment-grade bonds and now high-yield bonds," he said. People talk about opportunities in high yield because on a relative basis it looks good. At the moment the world is enjoying low inflation and we have very low interest rates, but at some point those things will change and that poses a risk. This week the private bank Coutts released a statement to "clarify" its position on high-yield bonds following reports that it was warning clients against exposure to the sector. "We are cautious on certain high-yield sectors, including Asian high yield," the bank said. But, it added, high-yield bonds are sufficiently compensating investors for the risk. There have been warnings about a potential bubble in the bond market for a while, and fund managers acknowledge that quantitative easing policies have pushed up high-yield bond prices, putting downward pressure on yields. Taking on greater risk has paid off over the past year, says Brian Dennehy, managing director of FundExpert.co.uk. But investors are no longer being rewarded with the same sorts of yields. The yield on the Kames High Yield Bond fund, for example, has dropped from above 7.5 per cent a year ago to just over 5 per cent now. However, Dennehy says that chasing yield can be dangerous at a time when yields are falling and new bond issues are so popular. "If a fund is increasing its yield then it's likely that the quality of underlying holdings has deteriorated," he said. You will find that a number of high-yield bond funds, the conservative ones at least, have been changing their holdings and this is contributing to lower yields offered. Dean Turner, investment strategist at HSBC Private Bank, says that falling yields on bonds have had an impact on the way in which investors diversify their portfolios. "We have become more cautious on bonds as a whole in recent months," he said. We are looking at other asset classes that can fulfil the sovereign bond's traditional safe haven role - such as commercial property and hedge funds. PSigma has also been re-focusing its client holdings away from large bond funds but has retained exposure to smaller funds such as the Airlie US Select High Yield fund, which invests in smaller US high-yield bonds. This is an area that Becket says most large high yield managers completely ignore. Adrian Lowcock at Hargreaves Lansdown also believes investors do not need to completely eliminate their exposure to high-yield bonds, so long as they think carefully about where to invest. The uncertainty about the market benefits managers that have some flexibility, he said. Hargreaves Lansdown favours Jupiter's Strategic Bond Fund, managed by Ariel Bezalel.