In this video update, Tom Ross, corporate credit portfolio manager, looks at the high yield bond market, exploring how technical conditions, dispersion among credits and blurred lines in valuations are creating opportunities.

Key takeaways:

• Technical conditions remain supportive, with limited new issuance yet strong investor demand. Negative interest rates, notably in Europe and Japan, are encouraging a reach for yield are making European bonds even more attractive for US dollar-based investors after accounting for currency hedging.
• Dispersion has risen across high yield markets, providing more opportunities for active managers to exploit. Valuations within different credit rating bands have become more varied across regions
• Blurred lines in valuations, particularly around the cross-over space between investment grade and high yield means it is possible to identify mispriced opportunities, including rising stars and investment grade bonds trading with more attractive yields and prospects than some high yield bonds.

View transcript

The technical conditions for high yield are currently very supportive. What do we mean by those technicals? Well, we’re talking about both the supply and the demand.

The supply of bonds, let’s start with that, is in fact very supportive. So this involves both the amount of new issues we have to the market and whether we look globally, the low-growth environment means that there aren’t companies doing large merger and acquisition (M&A) transactions, which typically causes that spike you will see in high yield bond financing.

There is not so much supply from issuance, but also we actually have, in some cases, net negative supply because we have bonds being taken out of the high-yield market. For example, the Wind Tre bond capital restructure, €10 billion of European bonds have been refinanced from the market through an investment grade entity. So that’s net negative supply we’re seeing to the market.

And clearly as well when we have upgrades to some of those high yield companies, the rising stars back to investment grade, this is effectively sucking supply out of the high yield market.

Now, if we then look on the demand side, negative rates, the grab for yield, is really driving investors to look for bonds and investments that have high income, and clearly high yield bonds is one of the areas that’s benefiting from that.

Negative rates are supportive for high-yield spreads in our opinion because it’s the case that investors are being forced out of low-yielding assets and into high-yielding assets, with high yield being a really great example of that.

The advantage as well is that central banks are not only providing negative rates, but they’re also providing assurances that rates will stay low for a long period of time. And that’s giving investors more confidence that they can reach for yield in the longer term, not just in the short term.

If we take those low relative yields that we have in Europe, it’s not necessarily always the case, especially for dollar investors. Because when a dollar investor is buying those European high yield bonds, when they then hedge them back into dollars, as we do for our global high yield strategy, you’re then getting a better yield on that after that currency hedging. So ultimately it creates a more attractive yield for those dollar investors.

We continue to see dispersion between different sectors within high yield, maybe not quite to the same extent as we saw in 2018 but still providing opportunities for us to position relative to our benchmarks.

If we take, for example, the transport and healthcare sectors, they have tended to underperform so far this year relative to the other sectors.

Within transport, if we take an area such as shipping, where in fact not only have we just been underweight, we’ve in fact been short as well. Shipping is really getting impacted on two sides: both the lower demand from lower growth but also the introduction of IMO 2020, which will come into place at the start of next year, which will require high-cost, lower-sulphur fuel to be used within all of their ships.

So that two-impact approach is really starting to hurt that sector, and where there are some names that have quite a lot of leverage, that’s really the area we want to exploit and take an underweight or short exposure.

Single-name dispersion within the European high-yield universe has been a real theme over the past 18 months. A great opportunity for us as active managers through fundamental research is to avoid those losers and outperform our benchmark. Interestingly, within the US, that theme of single-name dispersion only really came into play around two to three months ago.

And Seth, my co-manager on the global high-yield strategy, and the analysts based in Denver were probably getting a little bit bored of all this talk of dispersion within the European market. But when we were asking that question, when do you think dispersion will pick up in the US, that then really helped them to be able to prepare for an environment of increased dispersion within the US and really allowed them to then avoid the losers within many of the US names that have then started to fall over in the past two to three months.

In terms of our regional allocation within our global high-yield strategy, we’ve tended to be overweight European risk, relatively neutral through the US, and then slightly more underweight through emerging markets. That has really benefited the strategy, as emerging markets have struggled, especially with situations such as Argentina.

But more broadly, Europe has tended to outperform based upon a more supportive central bank in the ECB, the negative rates, and the potential for central bank purchases as well that have really driven European high-yield spreads tighter relative to the other two regions.

But now we’ve seen such a level of underperformance within the emerging market region that now we’re looking to start to increase emerging market risk and reduce some of that European risk, since it’s already outperformed so far this year.

Also, if we start to look more specifically within the rating buckets, the dispersion within European high-yield has actually meant that European double B (BB) rated bonds, where there’s less dispersion, now trade very tight relative to US double Bs, partly a function of the central bank driving investment-grade investors into double Bs to search for yield.

Whereas, when we then look within single Bs, actually European single Bs trade wide to US single Bs. So there’s potentially some more opportunities there if we do appropriate stock picking, given we still have quite a high level of dispersion within that part of the market.

Can high-yield spreads retest the tights? If we take the post-global financial crisis, tights versus swaps of 295 basis points, we are currently trading at around 400 basis points in spread. So there’s quite a bit to go before we get back to those tight levels, and I think ultimately in order for us to get there, we probably need some of the risks within the market to recede. Things like US-China trade talks, possibly Brexit, maybe a favourable market outcome for the US primary elections.

If we had a couple of those things, then I think there’s a good chance, with the support of central banks, even in a low-growth environment, that we could start to see tighter spreads. But even before then, high yield still remains fairly attractive for investors, not least the yield and carry available from investing but also there’s quite a bit of tightening to go before we even do retest tights, which could result in some capital appreciation.

The crossover space between investment grade and high yield is a huge opportunity within the high-yield market for active managers. With our structure of analysts covering through the entire rating spectrum of investment grade and high yield, it puts them very well placed in order to try and find and exploit these opportunities.

Clearly, rising stars is a well-flagged way of trying to exploit those, and if we take examples of Tesco earlier on this year and potentially a company like AXA PPP maybe later on this year, they’re great examples of rising stars that can really add to performance through picking those correctly.

But it’s also about the blurred lines of valuation we have between triple Bs (BBB) and double Bs (BB). Within Europe, the BB index currently yields inside of 2%, whereas we have BBB securities in a subordinated Volkswagen bond that yields greater than 3% and a subordinated bond of a company called Aroundtown, which is a European REIT (real estate investment trust), which has a yield of greater than 4%.

So those blurred valuations provide some really great opportunities for us to invest in improving companies with better yields than we would get from investing in a more generic BB market.

Notes:  

In the video Tom refers to credit ratings, which are scores assigned to bonds or issuers according to their creditworthiness by credit rating agencies. Bonds rated BBB which is an investment grade rating, are deemed to have a higher (better) credit rating than bonds rated BB which is a sub-investment grade (or high yield) rating, which are in turn deemed better than bonds rated B. 

References to BB and B indices refer to the ICE BofAML US High Yield B Index, the ICE BofAML US High Yield BB Index, the ICE BofAML European Currency High Yield B Index and the ICE BofAML European Currency High Yield BB Index and the LIBOR option-adjusted spread (OAS). Spread differentials were correct at end September 2019 but may vary over time. 

The reference to global high yield tights relates to the lowest recent spread on the ICE BofAML Global High Yield Index which was 295 basis points in January 2018 on a LIBOR OAS basis. 

References to Volkswagen and AroundTown relate to the AroundTown SA 4.75% FIX/FRN perpetual subordinated bond and the Volkswagen International Finance NV 4.625% FIX/FRN perpetual subordinated bond. Yields mentioned were correct at end September 2019 but may vary over time. 

Crossover relates to bonds with ratings close to the border between investment grade and high yield. Rising stars are bonds/issuers that are upgraded in terms of credit rating from high yield to investment grade.