Insight

Why high yield now?

Why high yield now?
Overview
1
  • High yield currently presents an unusual opportunity: Yields are elevated while fundamentals are solid.
2
  • We believe high yield issuers’ ability to absorb a mild recession has never been better.
3
  • We currently favor high quality, short duration high yield, and a focus on the energy sector.

We believe high yield currently presents an opportunity that investors seldom see. Yields are elevated and credit fundamentals are solid, a positive combination when it comes to potential investment outcomes. We speak with Niklas Nordenfelt, Head of High Yield, and Portfolio Manager, Rahim Shad, about the historically unique situation facing high yield today, and what it means for their investment strategy.

Q: Why invest in high yield when we are potentially going into a slowdown?

Niklas: We believe we are facing a rare opportunity in high yield today, one seldom seen by investors. Currently, we can invest in 8.5% yielding bonds (the average for the high yield index) issued by companies paying less than 6% on those bonds.1 This probably won’t last forever, and most of these issuers will likely have to refinance their bonds eventually at higher rates. But, for now, we get the benefit of high income paid by fundamentally healthy issuers enjoying low interest expenses. We do believe issuers will face a more difficult backdrop if there is a recession, but their ability to absorb a shallow recession has never been better, in our view. Currently, high yield net leverage and interest coverage metrics are at, or near, all-time best levels (Figures 1 and 2). The asset class has fewer lower-rated and more highly rated bonds than usual, near-term maturities are manageable, and we do not expect the default rate to reach previous peaks.

Figure 1: Net leverage ratio (net debt/last 12 mos. EBITDA)

Source: JP Morgan, Capital IQ. Data as of Dec. 31, 2022.

Figure 2: Coverage ratio (last 12 mos. EBITDA/last 12 mos. interest expense)

Source: JP Morgan, Capital IQ. Data as of Dec. 31, 2022.

Q: Given recent market volatility, is the new issue market functioning well?

Niklas: Yes. It came to a screeching halt in March, but as rate volatility has subsided, the market has re-opened and is functioning very well. We don’t believe a lack of demand for bonds, or a non-functional new issue market will be a meaningful source of bankruptcy risk in the near future. But the nature of issuance has changed in recent years and that change has accelerated this year. The high yield market is typically populated by new issues with aturities of seven to eight years with a non-call period of three to four years, and these issues are mostly structured as  unsecured bonds. This year, we’ve seen a large increase in secured issuance with shorter tenors. Issuers have been reluctant to “lock-in” long-term debt at current levels and, instead, have focused on five-year tenors on the premise that they will be able to refinance at lower rates in the future. Meanwhile, to induce investor interest, issuers have been issuing secured bonds. Over 60% of this year’s new issues have been secured.2 As a result, nearly 30% of the high yield market is currently secured.3 Secured bonds tend to have higher recoveries in the event of defaults. In short, the quality of the index, which was already historically high, has improved with the increase in secured and shorter tenor bonds. This bodes well for high yield’s longer-term risk-reward characteristics, in our view.

Q: What’s the most compelling trade in high yield today, in your view?

Rahim: High quality, short duration high yield is our “pound the table” call. While this strategy has historically provided strong risk-adjusted returns, there are two factors worth highlighting: First, today’s starting yield levels are some of the highest we have seen combined with prices well below par.4 This can provide an opportunity to capture significant capital gains in the event of an early tender or special call due to merger activity. Second, yield curve inversion has created a unique situation in which one to five-year maturity bonds are yielding more than longer dated bonds.5 The value proposition gets stronger as we move into the higher quality segment of short duration, where a defensively positioned portfolio can be constructed without a significant give-up in yield.6 We believe current fundamentals will allow companies to potentially weather economic turbulence with minimal defaults, even during periods of stress.

Figure 3: Global bond yields per unit of duration

Source: Bloomberg L.P., Global Short-Term HY is represented by the BBG Global HY Corporate 1-5 Year Index, Global HY is represented by the BBG Global High Yield Corporate Index, Global Credit is represented by the BBG Global Aggregate Credit Index, Global Agg is represented by the BBG Global Aggregate Index, EM Hard Currency Agg is represented by the BBG Emerging Market Hard Currency Agg Index, Global Securitized is represented by the BBG Global Aggregate Securitized Index, Global Treasury is represented by the BBG Global Aggregate Treasury Index, Global ST Agg (1-3) is represented by the BBG Global Aggregate 1-3 Years Index. As of March 31, 2023.

Q: How did the recent banking crisis impact the high yield market?  

Niklas: Normally, when there are market stresses, high yield finds itself in the middle.  Currently, the areas of most obvious stress have been in the banking sector (especially, smaller regional US banks), commercial real estate and start-up technology firms.  None of these have much direct linkage to the high yield market. Nonetheless, risk aversion in other areas of the market can drive spreads wider in high yield. We saw this in March, but high yield has since retraced those losses. As investors, we find dislocations and forced selling to be interesting opportunities.  In the case of the banking crisis, we identified a number of attractive investments. In general, we seek to take advantage of high yielding opportunities where we feel the risk is well managed, at both the portfolio and issuer level.  

Q: Which sectors do you favor in today’s environment? 

Rahim: We like energy at the moment. In our view, spread levels reflect improvement in the credit quality of the sector and its trajectory, as companies exhibit capital discipline. Our focus has been on oil field services, which should continue to benefit from increased activity in on-shore and off-shore drilling amid supply side challenges. We expect several upside catalysts as we head into summer. First, aggregate demand should pick up with the driving season and as China reopens from its COVID lockdowns. Second, the US Strategic Petroleum Reserve will need to be refilled eventually. On the supply side, the US remains rangebound with no expansion activity so far. Within consumer cyclicals, we see value in a couple of segments that could benefit from a resurgence in travel. Cruise lines, for example, are set up well in this environment as there is pent-up demand for vacations but travel has gotten expensive over the last few years and cruises tend to offer good value for the money. The other area is casinos, especially in Macau, where operational results should improve significantly as China reopens. 

About risk

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Junk bonds involve greater risk of default or price changes due to changes in the issuer’s credit quality.

The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

All fixed income securities are subject to two types of risk: credit risk and interest rate risk. Credit risk refers to the possibility that the issuer of a security will be unable to make interest payments and/ or repay the principal on its debt. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

Footnotes

  • 1

    Source: Bloomberg US High Yield 2% Issuer Cap Index. Data as of April 24, 2023.

  • 2

    Source: JP Morgan. Data as of March 31, 2023.

  • 3

    Source: ICE BofA Global Research. Data as of March 31, 2023.

  • 4

    Source: Bloomberg L.P. Bloomberg Global Corporate 1-5 Year High Yield Index YTW 9.02%. Data as of April 21, 2023.

  • 5

    Source: Bloomberg L.P. Bloomberg Global Corporate 1-5 Year High Yield Index YTW 9.02%. Bloomberg Global Corporate High Yield Index YTW 8.65%. Data as of April 21, 2023.

  • 6

    Source: Bloomberg L.P. Bloomberg Global Corporate 1-5 Year Ba/B High Yield Index YTW 7.91%. Data as of April 21, 2023.

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