The last several months have been brutal for risk assets. An environment of monetary and fiscal policy tightening has led to credit spreads and yields going up, as well as increased dispersion between cyclical and non-cyclical sectors. The Russian invasion of Ukraine has deepened investor fears and short term inflationary pressures, particularly in commodities.
Leading economic indicators are pointing to recession being just around the corner, as Covid effects linger, war catalyses inflation, and the sugar rush of stimulus fades away. Consumer confidence in developed markets, a major driver of the global economy, is at its lowest level for decades, while US mortgage rates and housing affordability are back at levels seen just before the global financial crisis.
So far, so depressing? Maybe not. Fixed income investors have a reputation for taking a glass-half-empty view of markets, given that the optimal risk/return balance of the asset class necessitates protecting against permanent credit losses. But in fact, from current prevailing yields, we’re currently pretty optimistic about the medium- and long-term potential returns available in global high yield credit.
The devil’s in the detail
We’re in no doubt that the world economy is slowing and that, even if one sees inflation as transitory, it seems inevitable that the economic news will get worse before it gets better. A slowing economy combined with hawkish central banks are a powerful headwind for risk assets, including high yield bonds. However, the question which we must always ask ourselves as investors is: to what extent do available yields already reflect (and therefor compensate for) these expectations?
Global HY spread, 10 years versus average
As of 30.06.22. Source: Bloomberg. Global HY is ICE BoFA Global High Yield Constrained Index.
Global HY yield to maturity, 10 years versus average
As of 30.06.22. Source: Bloomberg. Global HY is ICE BoFA Global High Yield Constrained Index.
Global high yield, as represented by the ICE BoFA Global High Yield Constrained Index, offers 642bps of spread (OAS, source Bloomberg, USD, as at 30.06.2022), with a yield to worst of 9%. Over the last 20 years, credit spreads have only been higher 23% of the time; and over the last 10 years, credit spreads have only been higher 8% of the time. Historically, when all-in yields have risen to current levels, future returns for high yield as an asset class have been strong, as shown below.
Distribution of historical Global HY 12m returns with starting YTM between 8% and 9%
As of 30.06.22. Source: Bloomberg. Global HY is ICE BoFA Global High Yield Constrained Index. Since 31.12.1997.
Nevertheless, this is not an environment for complacency. In bad recessions, credit spreads can move significantly higher for a period of time: the historical average spread during recessions since the late 1990s was much higher at 1065bps. So, although global high yield credit is currently at a level which historically has represented a strong entry point for medium term returns, we are in a more volatile and dangerous short term risk environment. Company business models will be stressed by tougher market conditions, and liquidity for bond issuers will be less available and more expensive. This is an environment that requires rigorous, fundamentally oriented credit research, combined with a robust macro framework that reflects the underlying economic trends. If an investor can be active in their allocations, and is part of a team with the resources and market experience necessary to identify relevant risks, then we believe there should be plenty of scope for outperformance.
That point about the detailed credit research is important, not just into individual issuers but also down to the level of individual bond issues. High yield credit is sometimes compared to equity investing, but one of the ways in which the two differ is that equity investing is on its face much simpler: a company will typically have a very small number of different share classes, and the differences between them (re: dividend policy or voting rights, for example) are readily apparent.
In high yield credit, however, the maturity profile, coupon, seniority and covenants of specific issues can vary in subtle but significant ways, even among bonds from the same issuer. This is a dynamic that we believe rewards close analysis from a large and experienced credit team, as well as an active, high conviction approach to portfolio construction. In bull markets, much of the nuance between different sectors, issuers and bonds is often lost. In bear markets, detail is everything.
Markets are not yet at peak fear, so tread carefully
For all the talk in the media and among market commentators of economic pain and recession, in many ways that outlook isn’t reflected in how investors as a whole are positioned. There is still a tendency for investors to be very long equities, for example, and other widely followed indicators such as the VIX index remain relatively calm. It is interesting that credit has experienced some of the most dramatic repricing against a backdrop of inflation and interest rate fears, with significant outflows relative to equities. All-in-all, markets may not yet have reached peak fear across all asset classes, and so a further material deterioration in sentiment for risk assets should probably be expected until enough damage has been caused for inflation and interest rate expectations to fall, leading central banks to tone down their hawkish policy stance.
For us, dipping toes cautiously back into the water feels like the right thing to do, because spreads and yields have moved a lot and in many areas look attractive on a through-cycle basis, but we certainly don’t want to be positioned too aggressively, or invested too cyclically. That’s reflected in which sectors we currently identify as offering value. Consumer discretionary seems to us like the main one to avoid: it’s already starting to crack a bit, but could really implode. On the other side of the coin, we have a strong preference for more defensive sectors such as utilities, telecoms, and packaging. We also want to hold high levels of government bonds and cash to hedge against a further sell off in risk.
Energy is an interesting topic. Obviously it’s an area that’s been a profitable investment recently, but on a forward looking basis we believe the picture is more nuanced. Right now the focus is on the supply side of the energy market, with everything that’s going on in Ukraine, but in a recession you could see quite a sharp drop off in demand. We believe investors should start thinking about whether or not an overweight in energy makes sense based on where we are today.
As ever, the future is unknowable, but it’s our view that over the next year or so there are good risk-adjusted returns to be had from global high yield credit. How bumpy the road might be remains to be seen, however. History has shown that when high yield spreads move they can do so very sharply (as the chart above shows), so if any investor out there is looking to perfectly time that move we wish them the best of luck. The more prudent approach might be to have a strategic allocation to high yield across cycles, making use of detailed analysis on specific credits to avoid the losers and achieve attractive returns over time.
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