In this video, Tom Ross, corporate credit portfolio manager, discusses the global high yield market, exploring the near term outlook, whether defaults might pick up and where they are seeing the best opportunities.

Key takeaways

• The crossover space between investment grade and high yield globally continues to offer an attractive hunting ground as valuations and yields do not always reflect the assigned credit ratings.
• A continuance of low but positive growth could see spreads grind tighter but there are several catalysts from politics to technical concerns in the loan market that could cause spreads to widen.
• There is no real need for European high yield companies to lever up so we do not expect significant net supply in Europe, which together with an accommodative central bank should create a supportive technical backdrop for this region.

View transcript

Has relative economic weakness and lower yields influenced your weighting towards European high yield?

Recent economic weakness has actually been offset by the more positive market dynamics within the high yield market especially within Europe, given the more supportive central bank. So that’s actually leading us despite the poor economic outlook, to be more positive on the European high yield market.

The size of the European investment grade market has grown while high yield has been static. Is this trend set to continue?

So the recent trend of growth in the size of the European investment grade market and stability within the European high yield market we believe is going to continue into the future. European high yield companies don’t have a significant need to lever up (increase leverage). There’s not much M&A (merger and acquisition activity), so we’re not expecting significant net supply. And then within European investment grade this is an opportunity for all of the European companies to do exactly what UK and US companies have been doing for years – terming out their debt (extending the term), not just to 10 years or 15 years but out to 20, 30 years that they haven’t structurally been able to do because of the lack of demand for that part of the curve. We expect that’s already started. We expect that’s probably going to continue. And therefore there might be some opportunities in the longer end part of the European investment grade curve.

Do you anticipate the crossover area remaining a key source of return?

We continue to be excited about the opportunities within the crossover space of the market. It’s been a huge area of potential return for us in the past and we continue to think it will be in the future. The structural nature of the market, with high yield and investment grade being so separate, means that there aren’t that many investors that are trying to really take advantage of the opportunities within there. We’re not just buying those investment grade bonds because they’re more defensive, there are better opportunities, there are some better yields available than you’re getting typically from a BB type universe. Also by exploiting rising stars and also avoiding fallen angels, it’s a really great way to try and enhance returns within our flexible products. Some examples within this crossover space on the rising star side: it could be a name within the UK such as Tesco (the supermarket group) or maybe within the US a name like Equinix (the data centre company): we think they are really great examples of rising stars. Or it’s simply just exploiting those blurred lines of valuations.

What key factors could catalyse a tightening or widening of spreads?

So when considering the catalysts for spread widening or tightening. In fact, there are not really catalysts for spread tightening, it’s more the case that if we continue to see low levels of growth but not too significantly low, and any trough in the global economy that’s likely to lead to spreads to continue to grind tighter as investors look for yield. On the downside, on spread widening, then we’re starting to talk more about catalysts, whether it be the US primaries and the chance that if Elizabeth Warren (Democrat presidential candidate) were to get in that would be negative for some of the US high yield sectors, namely energy and healthcare. Or let’s take the loan market where there are technical situations around the number of low-rated Bs that could get downgraded to CCCs which would then impact through into the collateralised debt obligations (CLOs) and their demand for the markets. Those are some of the things that we’re monitoring very closely on the negative side. And if any of those risks were to dissipate, again, that would probably make us more positive.

Do you anticipate a pick-up in defaults in 2020?

We do anticipate a small pickup in defaults across the entire global high yield market. But this is purely a function of the underperformance of a number of bonds within the high yield market that we’ve already seen. The default rate tends to be quite backward-looking and a lot of those losses are actually felt by the market long before the companies actually then file for bankruptcy. But yes there will be a small pickup especially within the energy sector within the US where we’ve already seen a number of bonds fall in price.

The question is going forward how much more market volatility, how much idiosyncratic behaviour are we going to see within the market, and obviously then how are we looking to avoid those defaults? We’ve done a very good job over the last 18 months and we’re going to continue to perform that rigorous credit analysis to try and avoid those names that we don’t believe are going to be able to see through this period of low growth. Some companies are fine but we have to be wary of those maybe with high leverage or not quite with the right sustainable business model or sustainability in terms of ESG. Those are the areas we’re slightly more concerned around and those will be the names we’ll be trying to avoid.

Is there a region or sector that you particularly favour?

So looking ahead to 2020 from a regional perspective we still favour Europe but we’re also looking to favour emerging markets as well given the better valuations we now have within that market. We’re still a little bit cautious on the US, based upon concerns around mainly the energy sector but also areas of healthcare and also some of the wireline communication businesses.

When we start to consider from a sectoral perspective we favour areas such as the real estate market within Europe. These companies are continuing to do what they said they would: improve their capital levels, reduce their loans to values, and look to get those upgrades back to investment grade. And also areas like financials and additional tier ones. They offer a great opportunity to invest in financials that have better capital levels right now but get the better yields from being further down the capital structure. But we’re comfortable doing that given the stability of the some of the national champion banks that we’re investing in.

 

Notes
Rising stars: Bonds that are rated sub-investment grade and are on the path to being upgraded to investment grade
Fallen angels: Bonds that were previously rated investment grade and are downgraded to sub-investment grade
ESG: Environmental, social and governance refers to criteria that investors can use to asses a company in terms of sustainability. Environmental criteria can include a company’s use of resources and how it meets environmental regulations, social criteria consider how a company manages relationships with the community and stakeholders and is responding to demographic changes, while governance criteria cover areas such as management controls and accounting integrity.
Wireline: This refers to information and telecommunication services where there is transmission of data over a physical filament. Examples include copper-wire telephone networks, cable television and fibre-optic communication.