In the often-quoted ‘hunt for yield’, investors have stretched themselves in efforts to secure better returns on their investment but opened themselves open to more risk Lundie said.
With volatility on high yield credit generally lower than that of investment grade in recent months, investors have been complacent but Lundie, co-head of credit at Hermes, said “there is no reason to believe that this is the new normal”.
With a rise in interest rates on the cards, he warned investors it would result in a spike in volatility as compared to the lows recorded by the VIX index over the past few months.
Any rise of volatility would ultimately normalise the relationship between investment grade and high yield.
“Those investors that have stretched themselves to take on greater risk may face a range of nasty surprises. The risk of right sizing positions could put downward pressure on the market due to forced selling,” Lundie said. “At the very least, these investors are unlikely to have the dry powder to take advantage of opportunities to enter or add to positions at attractive levels should a sell-off occur.”
He stressed that over the long term, high yield would remain “emphatically” more volatile than higher quality bonds.
Lundie said: “While high-yield volatility has trended lower for several years, there is no reason to believe that this is the new normal.
“Nonetheless, investors have become complacent in their allocations to this area of the market, potentially risking oversized positions that they would be challenged to refocus in the sort of market turn that is starting to seem more likely.
“It is essential that investors actively manage the size of their allocations if they are to manage their risk effectively.”