High yield, high potential

The value of an investment in the Fund, and any income from it, can fall as well as rise. Capital at risk. Past performance is not a guide to future returns.

Sandy Jones (SJ): Welcome, and thank you for joining this webinar for the Baillie Gifford High Yield Bond Fund. My name is Sandy Jones. I'm an investment specialist for corporate credit, and I'm joined by Faisal Islam, co-manager of the strategy alongside industry veteran Arthur Milson. Faisal has been a high yield bond investor at Baillie Gifford since 2018 and has 14 years of industry experience.

We're going to give a short presentation of around 25 minutes, outlining why we're excited about the asset class at the moment, our current positioning, and a small sample of our best ideas. Then we're going to move on to Q&A. We're very keen for this to be interactive, so please submit questions using the Q&A function, and we'll return to these at the end of our presentation.

We titled this presentation, "High yield, high potential: Why high yield deserves a place in your portfolio". The key theme here is that the risk-adjusted return potential of the asset class currently looks very attractive. Simply put, current yields are high relative to history, which not only provides a solid platform for future total returns, but also a cushion against capital drawdowns in the event of volatility. So, with this in mind, I'll now hand over to Faisal to begin our presentation. 

Faisal Islam (FI): Yeah, thank you, Sandy. I am delighted to be here to discuss the merits of high yield bonds. This is an asset class that we believe remains firmly underappreciated by the broader market. To set the scene, I just wanted to start by outlining the current yield environment, which is a key indicator of the asset class's return potential. 

The chart on screen highlights the evolution of yields in the high yield market in the past decade. And what excites us is the clear paradigm shift in yields in the past three years. We've left behind that 3 per cent, 4 per cent world of 2022. Today, all-in yields in local terms are around 6.5 per cent and even higher when hedged into Sterling of around 8 per cent following central bank rate hikes.

To bring this to life, let's consider Virgin Media, which is a regular high yield issuer. As a household name with a strong market position and recurring revenues, it's a great example of the opportunities in our market. Now, three years ago, Virgin Media could come to the market and issue bonds at 4 per cent, and they did. But today, if they came to the market, they'd have to pay around 6.5 per cent or 7.5 per cent, depending on the bond's maturity and structure. We see this as exceptional value for such a robust blue-chip name, hence, Virgin Media is a core holding in our portfolio. What this example also highlights is a key dynamic in our market, which is this. If you invest in a Virgin Media bond today, you're receiving those annual coupons of, let's say, 7 per cent in Sterling. But you're most likely to receive your principal back in just 2030, so that's just five years from now. 

Why so soon? Well, most high yield bonds are redeemed within four or five years, so your capital is not locked up for too long. And so, if your investment horizon matches this, around that five-year mark, and you do your credit work, which we do as highly active investors, you can just focus on those steady income payments. The price swings in the interim period become less of a concern. So, our highly selective active approach allows us to identify names like Virgin Media and lend to them with confidence. So, the reliability of this income stream is what truly sets high yield apart.

Coupons are contractual. They cannot be switched off at management's discretion, unlike dividends. And over that typical five-year period, most of the returns in our asset class are coming from income, not capital movements. And so, with yields at multi-year highs, we see a compelling opportunity for portfolios seeking reliable, attractive income. So, we've said yields are really attractive, but do investors need to take on more risk to achieve them? After all, high yield is often referred to as junk bonds. We think unfairly. We think that label is completely outdated. So, the chart on the left-hand side of the screen shows the growth of the high yield market by credit rating in the past 20 years. 

And there's two really important things that I wanted to highlight here. Number one, the opportunity set has vastly increased over time as the market has broadened, it's deepened and it's matured. The size of the market has effectively doubled in the past two decades. And secondly, if we notice that dark blue shaded area that represents double B rated bonds, this has increased far more quickly than the lower rated single B and triple C part of the market. So today, over 60 per cent of high yield bonds are rated double B, and that's the highest tier in the category and just one notch below investment grade. And just for context, back in 2000, that figure was under 30 per cent. 

So, the quality of the market, in our view, has materially improved. Now, why does this matter? Well, it's because double B rated companies simply rarely default. According to the hard data, the chances of a double B bond defaulting in the next year are less than half a per cent. Even for single B credits, that blue line in the middle, it's under 3 per cent. The riskiest segment of our market, triple C bonds in the light grey, is less than 10 per cent. And we think this significant improvement in credit quality remains broadly underappreciated. 

Now, at the same time, the market is broader and deeper than ever. So, if we turn to the right-hand side of the slide, you can see just how broad and diverse the opportunity set has become. The three bubbles represent our core three major opportunity sets, so US high yield, European high yield, and additional tier one bonds issued by the major European banks. Together, these three segments encompass trillions of dollars and over 3,000 bonds spanning different geographies, different sectors, and different bond structures. Now, we only lend to 110 companies, so there's just a vast opportunity set out there for bond selection. And it's worth noting, many leading household names are part of this opportunity set. 

So we've mentioned Virgin Media, but we lend to household names like David Lloyd, The Gym Group, or Iceland, the food retailer, and Barclays Bank. Even global well-known brands like Netflix, Uber, Tesla, they've all issued high yield bonds in the past. The key point is this, many companies in our market are strong, sometimes growing businesses, and they choose this market for flexibility, not necessarily because they're risky. And these are the types of companies that we want to own at the right price.

So, for active managers such as ourselves, this vast and dynamic landscape offers ever-increasing ways to diversify and add value. So, rather than passively tracking an index, which can force exposure to maybe some of the riskier credits, we rely on rigorous bottom-up research. We avoid the weakest issuers and we focus in on our efforts, just on the most compelling opportunities in the market. So just to summarise, the idea that high yield contains excessive risk just doesn't hold up in our view. We think that commentators often overstate the default risk in our market, and history shows that despite lending to less credit-worthy borrowers, investors are more than compensated for these risks. 

So, is our view that this is not a junk asset class reflected in returns? The chart on screen shows your classic risk-return frontier over the past two decades for four main asset classes with annual returns on the left-hand side and annualised volatility at the bottom. And this is one of my favorite graphics because the message is loud and clear. High yield bonds have delivered equity-like returns of around 7 per cent per annum, but with nearly half the volatility. And I find that extraordinary. Especially this period includes some major risk-off events such as the global financial crisis, the European sovereign debt crisis, COVID, Russia's invasion of Ukraine, and, of course, more recently, the so-called Liberation Day tariff episode. There's always something to worry about or something unexpected around the corner but this long-term data here proves how your bonds are resilient and they keep on delivering that strong income. 

Now, let's turn to the rest of the fixed income universe. So, you can see investment grade bonds have returned about 4 per cent in the past 20 years, government bonds just 3 per cent. Now, both came with lower volatility, but noticeably lower returns. And that's your trade-off. We think that high yield sits firmly in that sweet spot, offering strong returns for a moderate level of risk. And it's worth asking what explains this impressive risk-return profile. There are three key factors that we'd like to highlight. So, the first is income. We've touched upon this. It's that steady coupon payments which compound over time, acting as a ballast during market downturns, whilst prices can fluctuate from year to year. Because most high yield bonds mature in four or five years, there's an almost gravity-like aspect to the bond price. The bond needs to pull to par very, very soon. And what this means in practice is that the asset class ends up being driven almost entirely by income return and not price return. 

The second reason, in our view, is that high yield investors are persistently overcompensated for the credit risk that they take. And we think this is due to the strict boundaries set by ratings agencies between investment grade, such as BBB issuers and high yield at BB. Once a company is rated high yield, its pool of illegible buyer base shrinks and this causes them to offer higher coupons and issue shorter dated bonds, I think five years rather than 30 years. But the key point is this, the extra yield paid to high yield investors far exceeds the actual credit loss they end up experiencing. You could call this a market inefficiency, but it's one that's likely to persist given the entrenched role of external credit rating agencies and that rigid divide between investment grade and high yield, combined with the conservative risk appetites of large institutions such as banks and insurers that can most of the time only hold investment grade assets. 

The third key reason we'd highlight is because of high yield short duration, investors are mostly taking credit risk rather than interest rate risk. And so, if you refer back to the chart, you can see global government bonds and the corporate indices have average maturities of around eight or nine years and effective duration of around six or seven years. What does that mean? So, roughly speaking, if interest rates go up by 1 per cent, those two asset classes could fall by around 7 per cent in price terms. A good example is Google Bonds in 2022. Obviously, Google, now called Alphabet, one of the best companies in the world, rated AA, so really safe. They were able to issue 40-year debt at 2.25 per cent. That matures in 2060. So when interest rates rose significantly in 2022, those super safe Google Bonds plummeted by 50 per cent because you're taking a huge amount of interest rate risk there. As of today those same Google Bonds are trading at 52 cents on the dollar, and they face a long long road back to recovery given the length of that bond. 

Now you don't get 20-60 bonds in the high yield market and as a result it's far less sensitive to interest rate movements. And so again, referring back to this chart, it's clear that interest rate risk has not been particularly well-rewarded in the past 20 years, whereas higher credit risk has. And this makes our asset class especially resilient during periods of interest rate volatility, and it makes it a very useful diversifier in balanced portfolios, given its low correlation to government bonds.

Today, as we said in the beginning, the global high yield market yields about 8 per cent hedged to Sterling, providing a very attractive indicator of forward-looking returns. Even after accounting for expected defaults, we can think about that 6 per cent or 7 per cent as long-term total returns being pretty realistic, pretty attractive, which is well ahead of the 2 per cent dividend yield on global equities, or say the 4 per cent yield on a five-year gilt. In summary, high yield is an attractive diversifier for any balanced portfolio. In my experience, investors simply don't hold enough. 

Now, we've talked about the long-term resilience of high yield bonds, but it is natural to ask questions about their shorter-term price performance, especially during major risk-off events, and that's a valid concern, so let's address it. The chart on screen shows the total return performance of global high yield bonds compared to global equities this year. So, as we can see, the so-called Liberation Day tariffs in April triggered sharp volatility across major risk assets. And at their lowest point, the S&P 500 faced a 15 per cent drawdown on the 8th of April. Unhedged investors in the UK, of course, also suffered a little bit of a double whammy as the dollar weakened against Sterling by about 7 per cent or 8 per cent. But what we'd highlight is that, meanwhile, the global high yield universe that we track slipped just one and a half per cent. So that's just one tenth of the drawdown of equities during a major risk-off event. Now this isn't to downplay the impact of tariffs on our market. The scale and breadth of the announcements were a genuine shock. Defaults became a concern and credit spreads did widen from 2.9 per cent to 4.6 per cent and especially so in cyclical and tariff exposed sectors. Yet, the broader markets decline was brief and it was shallow. The high yield market rebounded to break even within a couple of weeks. And as we pass the half year point, global high yield is up 4 per cent in total return terms. So very nicely tracking in line with that 7 per cent annualized pace that we talked about earlier. And that 4 per cent is driven mostly by the steady power of income. Actually 3.5 per cent of that 4 per cent is just clipping coupons. 

So, we think the Liberation Day episode is a powerful reminder of why high yield bonds deserve a place in a diversified portfolio. They offer robust income, you've got lower volatility than equities, and low correlation with government bonds, providing continued resilience in turbulent times. 

So having set out the strengths of our asset class, let's turn to how we're positioning the portfolio today. At Baillie Gifford, we're highly active investors. Our approach is rooted in rigorous bottom-up credit analysis, but we never lose sight of the bigger picture. So, every quarter, we step back and assess our portfolio positioning through the key pillars on screen, the macroeconomic environment, corporate fundamentals and valuation. It's a very simple framework, but it helps us proactively position the portfolio as market conditions evolve, depending on these three facets. If we start on the left-hand side with the macro backdrop, Liberation Day brought a wave of uncertainty with the breadth of tariffs prompting widespread recession forecasts. Since then, however, the tone has noticeably softened, and the hard economic data has proven a lot more resilient than many had anticipated. As things stand, US growth is expected to slow to around 1 to 1.5 per cent, which is a moderation, but still comfortably in positive territory. And over in Europe, fiscal stimulus plans appear genuinely transformative, in some cases adding a full percentage point to growth in countries like Germany. 

Now, of course, risks such as geopolitics and renewed trade tensions remain firmly on our radar. But with low inflation and ongoing growth as our base case, the environment for credit remains generally quite constructive. Return to, in the middle, corporate fundamental, the picture also remains quite robust. While some metrics such as interest coverage (so that's profits divided by interest coupons), have softened, they are coming off with artificially high levels given the low interest rate environment. So, they're back to being in line with long-term averages. Another indicator, which is leverage, as measured typically by debt to EBITDA, that is also around its long-term average of around three and a half times. And the maturity wall, the amount of bonds that are coming up for refinancing in the next couple of years, is not presenting major challenges at all as capital markets remain firmly open. So we're just not seeing major signs of excess. And this, together with the benign macro outlook, is being reflected in very low default rates. So a case in point, the US high yield default rate is currently below 1.5 per cent at the moment. That's less than half of its long-term average of 3 per cent. And so that just underscores the overall health of corporates in our market. 

Where there is stress, it is mostly contained to tariff exposed sectors such as retail or very specific to highly indebted companies way down the rating spectrum in triple C territory. So, in summary, corporate fundamentals are strong, which is another supportive factor in favour of taking credit risk here. 

Moving on to valuations, the picture is a little bit more mixed. The benign outlook, as we just discussed, is being reflected in credit spreads of around 3.5 per cent. So this extra spread over government bond, for lending to high yield corporates is below the long-term average. However, as we also discussed, all-in yields remain highly attractive, much higher than the past. The other thing worth flagging, an often overlooked factor is that the market is seeing a nearly 20 per cent shrinkage in the amount of bonds available to buy since 2022. And this leaves it well supported as yield-focused buyers have entered the market consistently since late 2023. So as such, we think high yield credit spreads of around that 3.5 per cent mark can remain fairly range-bound in the year ahead, leaving total returns in the next 6-12 months to be primarily supported by income. 

So, to summarise, the macro outlook is steady, we see fundamentals as being quite healthy, and yields are attractive. So this makes us reasonably constructive on credit risk. However, given where credit spreads are and the lack of pricing of some tail risks, we would be cautious and we are cautious about fully maximizing risk budgets at this juncture. So how does our macro assessment translate into current portfolio positioning? Our approach is relatively straightforward. We're looking to maximise income at this juncture, but not at the expense of taking excessive credit risk.

How are we seeking to do that? Well, we'd highlight three important ways. Firstly, the chart on the right-hand side shows the portfolio's credit rating in dark blue versus our benchmark in light blue. As you can see, more than half the portfolio is allocated to single B bonds, which is a deliberately large overweight position and reflects our relative levels of comfort with taking credit risk. The second way we're doing this is by being overweight Sterling high yield. This is a relatively small part of the global universe, just under 5 per cent of borrowers are on Sterling. Right now we have over 16 per cent of the portfolio in Sterling high yield. We often find that there's less eyeballs on our home market in a global context as such, there seems to be a persistent valuation discount for investing in Sterling issuers. We're happy to harvest that over the long term and we'll talk through some opportunities that we're finding a bit later. 

Thirdly, we think our edge comes from deep bottom-up research. We seek out bonds that are mispriced by the market. We're often finding opportunities where the risk of default is far lower than what the rating might suggest. As we talked about earlier, the market is hugely diverse, there are lots of idiosyncratic names, and sometimes the blunt tool of a credit rating, particularly in that single B category, completely misses the mark and obscures the kind of deep level of dispersion that we see at the individual bond level. And so, this is where we seek to add value. It's important to note that we're being selective as well about the risk we're avoiding. So we're avoiding the riskiest parts of our market. As you can see, our exposure to triple-C-rated bonds is less than 5 per cent versus 9 per cent of the benchmark. Similarly, we're underweight cyclical sectors, like automotive and retail, preferring defensive sectors such as healthcare and media. We just don't think we're getting paid enough for some of these cyclical risks, and so we're happy to be patient here. We're also maintaining a reasonably large cash buffer and we are using credit default swaps to hedge against future potential volatility. This ensures that we can act quickly when new opportunities arise and again showcases our highly active approach. 

To summarise, we think this approach strikes the right balance, capturing the most attractive sources of income in our market, steering clear of the riskiest segments such as CCCs, and ensuring the portfolio remains agile enough to seize opportunities from future market dislocations. I want to bring the portfolio to life right now by digging into some of our best ideas. And just to set the scene, when we're thinking about portfolio construction, we typically have two types of holdings in the portfolio. 

We have core holdings and we have opportunity type holdings. What do we mean by that? So, the vast majority of the portfolio is made up of core holdings. These are generally long-term, resilient, low turnover, income generating bonds issued by companies with very robust fundamentals and low earnings volatility compared to peers. So often in this category we're able to exploit a ratings arbitrage here, most notably within single B-rated bonds that in our view, once we've kicked the tyres, we think carries much lower risk than its rating would imply. These core holdings form the bedrock of their income generation and provide a consistent platform to out-yield the market over a credit cycle. 

Wagamama is a great example of a core holding. The UK high street has been pretty unforgiving for restaurants in the past decade or so, with many well-known brands disappearing, such as Jamie's Italian or Carluccio's. Yet Wagamama has not just survived, it has thrived. Its fresh brand, its Pan-Asian menu, seems to resonate across demographics and it's even the small touches like communal tables and unlimited green tea sets it apart. Its customer satisfaction score is really high up there with the likes of Nando's, which is the leader in the category. But most importantly, behind the scenes, the numbers are pretty compelling. Over 98 per cent of restaurants are profitable. The existing management team has stayed the business through Brexit, high inflation and economic headwinds. They've been actively managing their estate, keeping customers loyal, enabling price increases and growth in earnings. Importantly, when they've been rolling out new stores, they've been funding this from internal cash flow rather than through debt funding. And we like that approach because it supports both the sustainability of their growth in the long term, but also the sustainability of their capital structure. 

Now for bond investors, this is a rare opportunity. Wagamama is private. Shares are not available, only bonds. Their recent five-year single B-rated bond yields around 9 per cent, which is a standout in the sector. And when we did our work, we think the market is underestimating Wagamama's core strengths here and tarnishing it with the same brushes as those that have gone bankrupt. In reality, we think it's a cash-generative, growth-focused business with a management team we trust, and it's exactly the type of resilient core holding we want, offering astonishing value at around 9 per cent. To put that into perspective, these same bonds from the same company were issued at just 4.125 per cent in 2019. So, the market's just offering you double the yield for a business that's only just grown stronger with time, just because we're in a different yield environment. 

Let's move to the second type of holding, which is an opportunity type holding. And we're going to talk about some of our UK pubs. But just taking a step back, the objective of our opportunities allocation is it allows us to capitalise on thematic or event-driven ideas as they come along. So, these can be bonds that we think are maybe persistently mispriced and we're just kind of waiting for a future catalyst such as a refinancing trigger or an M&A takeout, for example. Or alternatively, these can be market dislocation events where market volatility has thrown up some sort of shorter term opportunity in a specific theme or in a sector or sometimes in a sub-asset class. And so, we can dynamically pivot the portfolio to take advantage of that market dislocation. The key distinguishing feature with an opportunity position is we're getting income return with these as well, but we're also targeting a price return element because we've identified some sort of catalyst. 

Let's turn to the two pub giants then, Marston and Mitchells & Butlers. We really like how they've been evolving with the times. Similar to Wagamama, they faced some pretty hefty challenges. Their doors were slamming shut during COVID, increases in the national living wage, tax hikes, etc. And they've also had to deal with a generational shift away from their core product of alcohol. Yet they've adapted really impressively. Marston has sharpened its focus, it's sold off its brewing arm to double down on community pubs. Mitchells & Butlers has reinvented itself from being primarily alcohol-led to food-led, a food-first destination. and that has been outperforming the industry in sales growth. Both have invested nicely in their estates, refreshed their brands, and have found new ways to keep people coming through the door. So now, whilst they've been executing on operations, as bondholders, we've seen years of cashflow being used to repay debt, which is to our benefit. And this brings me to the catalyst that binds these two holdings together. So both are bound by these legacy debt structures from the late 1990s known as whole business securitisations. Now without getting into the weeds, these structures keep management on a fairly tight leash. For example, they cannot pay dividends to shareholders. they're forced to reinvest their cash flow into their pubs, they have to stick to strict financial targets, etc. This has been fantastic for bondholders, it's led to deleveraging, but it's been quite frustrating for shareholders who have seen their capital tied up over some legacy bond documentation. So, we think the incentives here are pretty clear to refinance these structures well ahead of their maturity. And if they do that, there'll be a substantial premium to current trading levels. This sets up an attractive scenario for us. If nothing changes, we'll collect 7 per cent to 8 per cent in resilient income. But if management pulls the trigger on the refinancing, that's real upside potential. So we think mid-double-digit returns in the next year is possible, and that would be remarkable for a secured bond in a capital structure such as this. 

We particularly like this example because it shows the overlooked opportunities in our home market of the UK. We don't know exactly when this scenario will play out, but we're confident that it will. And when it does, it has significant value. And one of the key strengths of our approach is that we're genuinely patient long-term investors, and we're willing to wait months, quarters, or even years for our thesis to play out. So with that, I hope these examples have given you a flavour of the exciting opportunities currently available in the high yield market.

SJ: Thank you, Faisal. And thank you to those of you that have been submitting questions. We will come to these shortly. As a reminder, please do submit questions using the Q&A function. There is still time. From my perspective, there are really three key conclusions from today's presentation.

First of all, the current yield offered by the fund of around 8 per cent in Sterling hedge terms presents a really compelling entry point into the asset class. Looking ahead, the resilience high yield demonstrated during recent tariff volatility should give investors a lot of confidence. 

Second, the fund is positioned to capture attractive income without taking excessive risk. The fund outyields the market, achieved through a large allocation to B-rated bonds without significant exposure to triple C or distressed names, there is more risk of volatility. 

Finally, the portfolio is full of potential to outperform from the bottom up. We've talked about two of our best ideas in detail. These are just a few of the high conviction positions in the portfolio that hold the potential to add significant value through bond selection in our high yield bond fund.

Before we move on to Q&A, I want to give a quick overview of our proposition. Our approach is research-driven, high-conviction, patient and flexible. We hope that you've got a clear sense that our approach is primarily company research driven. Our team is really kicking the tyres on names such as Wagamama. We believe the greatest inefficiencies are found at individual bond level. So, the key focus of our team and our time is ensuring we consistently hold attractively valued bonds issued by resilient companies. This focus on resilience gives us confidence to invest with patience and conviction in a highly active, diversified portfolio of a 90 to 120 high yield bond issuers. This is not a quasi-passive strategy. 

Finally, we adopt a structured approach to portfolio construction designed to provide a platform for consistent alpha generation over the cycle. This comprises a well-diversified, low turnover core portfolio that captures attractive income and an opportunities allocation that holds the potential to deliver high total returns. Wagamama is a great example of a core position. Marston, and Mitchells & Butlers are examples of what we hold in opportunities. So, in summary, our approach is straightforward, successful, and on your side. 

The chart on the left shows the long-term performance of the fund, with each orange dot representing a single five-year rolling return period since launch in 2001. Had we performed in line with the iSterling High Yield Peer Group during these periods, the orange dots would sit on the grey line in the centre of the chart. Orange dots above the line represent periods of outperformance. And as you can see, our approach has outperformed over the majority of rolling five-year periods since 2001. So, in summary, we offer a highly experienced team and a long and successful heritage and high yield at a very attractive price. And on that note, let's move on to Q&A. 

Faisal, while I'm having a look at these questions, I'll go ahead and start with one. We've both talked about portfolio construction in terms of core and opportunities. Could you explain a little bit more about how we think about the balance of core and opportunities through the cycle? So when are we looking to maximise opportunities or maximise the core? 

FI: Yeah, so the Core Opportunities Framework is really helpful for us. And as I alluded to, the vast majority of the portfolio is probably core. So probably through a credit cycle, maybe three quarters of the portfolio would be core, made up of that kind of core income generation, clipping the coupon, structurally probably overweight single Bs to out yield the benchmark over a credit cycle and to enable that income to flow through. 

Then it's the opportunities framework which we can dial up and down depending on what market opportunities present themselves to us. So, you know, a couple of years ago when Credit Suisse went bankrupt, for example, there was a a huge opportunity in subordinated bank bonds, which plummeted in price. And we were able to go in and renew those names, Santander, Barclays, etc. And that was a specific market dislocation in a specific sub-asset class. And so, the opportunities part of the portfolio was dialed up there. Sometimes it's a theme. 

Another one, a good one, was the impact of GLP-1s on some of the healthcare names in the US, when those weight loss drugs were coming out with really good data, just led to extreme sell-offs in names like DaVita, which holds a duopoly in dialysis, and we knew that name, very cash-relative. We knew it was a short-term price opportunity, that's the key distinction, it's the short-term price decline that provides an opportunity for us. So, you know, it really depends. 

At the moment, you know, we're not seeing a lot in the kind of opportunity space. We do have 5 per cent to 6 per cent in European floating rate bonds at the moment. They've been really attractive in terms of harvesting income. So for a while, shorter term rates were higher than longer term rates. And so for the same exact credit, same exact issuer, you were collecting sometimes an additional percent in income just by holding the floating rate bond versus the fixed bond. So at the moment, because of where spreads are, the core allocation is probably 80-85 per cent, so more to that kind of ballast of income. But we're sitting, waiting, we're being patient, and we'll pounce when there's opportunity to present. So in summary, the income part of the portfolio is really a strategic part of the portfolio. It's all about harvesting income over time. And opportunities is what it says on the tin, it's about what dislocations are available. We'll maximise those depending on what we can see in the market.

SJ: There is one question here about default rates, which we briefly alluded to. So really pretty straightforward. What are current default rates and to what extent do you feel those are priced into the current market?

FI: Yeah, so the trailing 12-month default rate in US hike which is 50 per cent of our universe, is as low as 1.1 per cent. It's a bit higher in Europe, but I think for the universe that we track, it's around 2 per cent. And just to apply some sort of basic numbers on what that means for return. The average recovery rate of a higher bond is around 50 cents. So, if you've got 2 per cent of the market defaulting and then recovers 50 cents, you're losing if you will, 1 per cent. 

But the key point is your starting income right now is closer to 8 per cent hedged into Sterling. So, you know, you can flex your assumptions around default rates, and maybe they go up, but you have a pretty high and nice starting yield cushion. And so that really does reflect those benign default conditions are reflected in lower than average spreads, but we think that they're probably justified given defaults we think can remain lower than that average. It's a really important point that you've got to remember to factor in recovery rates into your assumptions, but overall 2 per cent is reasonably attractive. 

SJ: Final question here is a challenge around how attractive credit risk is relative to government bond risk at the moment. So the question is pretty simple. With government bond yields as high as they are, why own corporate credit? 

FI: It’s a fair question. I'd probably go back to what I was referring to as what risk you're taking there. So, with government bonds, particularly long-dated government bonds, and I know the 30-year gilt above 5 per cent is creating some headlines as being attractive, but it's important to know what you, you know, you're taking interest rate risk there. And so, you know, to be certain of generating 5.2 per cent in a 30-year gilt, you would have to have a 30-year time horizon to harvest that income. 

And in the interim, you can experience a lot of volatility in interest rate volatility has probably been higher than credit volatility in the past couple of years. So you'd have to have a pretty long time horizon. And if your time horizon is genuinely decades, then the returns in high yield are, you may as well invest in high yield and collect 7 per cent per annum. But I mean, I think it's important, we wouldn't say, it's kind of either or. Everyone's needs are obviously different, but we think high yield as a diversifier in a balanced portfolio is a pretty compelling proposition because high yield has a low and often negative correlation with government bonds. So, you can own both. And then, yeah, finally, its interest rates are higher. Government bond yields have risen, but I would be cautious about saying it was definitively a strong opportunity. 

I mean, there are risks, you know, fiscal deficit worries in the big G4 countries are there. So, it's sort of embedding an element of risk premium there for governments at the long end. And the supply picture looks quite challenging. I talked about the technical in the high yield markets being really robust, not enough supply for the flows, whereas the reverse is probably true in government land. So yeah, I wouldn't, sort of... I would be cautious in fully subscribing to the view that gilts are attractive, but in a diversified portfolio, I'm sure makes sense.

SJ: Yeah, I think the key point there is, as Markovits said, diversification is the only free lunch that's available. So, it's a diversification point. I think that's a good place to finish. If we have missed any of your questions, we'll respond shortly after the presentation. And if you have any more, please don't hesitate to get in touch with your Baillie Gifford contact. Faisal, thanks for your time, and thank you very much for joining us.

Annual performance to 30 June each year (net %)

Source: FE, Revolution, ICE Data Indices. Class B Inc shares. Total return net of charges, in sterling. Share class returns calculated using 10am prices, while the Index is calculated close-to-close.

*IA £ High Yield Sector

The manager believes an appropriate comparison for this Fund is the Investment Association Sterling High Yield Sector average given the investment policy of the Fund and the approach taken by the manager when investing.

Past performance is not a guide to future returns

Important information and risk warnings

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in July 2025 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

This communication contains information on investments which does not constitute independent research.

The Fund's share price can be volatile due to movements in the prices of the underlying holdings and the basis on which the Fund is priced.

Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the Fund invests, particularly in emerging markets, may not be able to pay the bond income as promised or could fail to repay the capital amount.

Further details of the risks associated with investing in the Fund can be found in the Key Investor Information Document or the Prospectus, copies of which are available at bailliegifford.com.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.

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