Investors Comparing Risk Adjusted Returns
Are Short Duration High Yield Bonds The Best Option Today? Investors see three reasons to lower duration in high yield bond allocations today.
High Yield is currently being researched intensely. Versus Global Government Bonds or Investment Grade Credit the yield on High Yield Bonds is high. But that investment argument is too simple. Here's what potential High Yield Bond investors are researching:
To answer this question, investors are comparing views on default rates, recovery rates to calculate their expected loss versus the current spread. Only then can they decide whether high yield bond markets are cheap, or not cheap enough. This exercise is also being performed for U.S., Europe and Emerging Market High Yield Bonds. What is interesting is that expected default rates vary widely across high yield bond investment managers.
The variation in expected high yield bond default rates is being driven by two factors: Firstly, investment managers views inside RFPnetworks differ widely on the global economic outlook - growth, interest rates and inflation forecasts. The resultant assumed economic base cases cover a wide range of scenarios. From a shallow recession to prolonged stagflation. And this varies again on a global and regional level (U.S. versus Europe versus Emerging Market economic outlooks).
The second related issue is whether the relatively strong fundamentals can be sustained. Corporate EBITDA is under pressure from rising rates, a strong dollar, rising input costs (e.g. tight labour markets) and the prospect of renewed supply chain constraints as Chinas buckles down on COVID again. So whilst EBITDA estimates have been revised down, the question is whether this is the start of some serial correlation. We've had the first downward revisions, but may be not the last.
Finally there is the impact of the recent stress in the banking system. To what extent will smaller firms be affected by tighter credit conditions and less liquidity in the system. This story is unfolding.
The research in this area is getting interesting. Investors are focussing on three characteristics of the short duration high yield bond market: Firstly, they are comparing yield levels on short duration bonds products to the broader high yield and investment grade bond market. And given the wide variation in economic outlooks across investment managers, they are analysing how short duration bonds perform in rising, flat, and falling rate scenarios. And then looking at the risk adjusted returns of short duration bonds versus the broader high yield market. The duration decision is a judgement on the depth and length of the recession ahead.
Short Duration Bond may look relatively attractive. But before a decision to invest gets a sign-off, a lot of research is happening behind the scenes with potential high yield investors. And only then does the real research begin. How do you find the best high yield investment manager for the current market environment and the diverse future economic scenarios that can happen.
Amid aggressive monetary tightening, the short duration profile of high yield bonds can help defend against rising rates.
Short-dated high yield bonds can offer enhanced yield, lower duration and higher risk-adjusted returns.
In the current environment, short-dated high yield bonds present interesting investment opportunities as they offer over 90% of the yield of the overall high yield market with about half the typical duration risk.
Positioning from CCC to BB
Where in the rating tables - from CCC to BB - should high yield bond investors be focused in 2023? Here's are global investment managers outlooks for 2023.
High Yield Bonds were a relative winner in 2022 in a year that saw every fixed income segment except cash deliver negative total returns. The question investors are asking now is whether spreads will widen further in 2023.
Current yields in both the U.S. and Europe are touching high single digits. Well above 10 year averages. High yield is delivering high yield. Which also means that being a corporate treasurer of a high yield rated corporate in 2023 will not be easy.
Refinancing the short duration liabilities characteristic of the high yield market will be very sensitive to the outlook for growth and inflation. Whilst margin preservation and expansion was possible during the covid period, in a recessionary environment, passing through higher input and labour costs to consumers will be tougher.
But these smart high yield corporate treasurers know this. Many have taken pre-emptive action by reducing balance sheet leverage and increased interest coverage to levels not seen since the early 2010's.
But whilst the fundamentals on average across high yield may look decent, investment managers and rating agencies are expecting default rates to rise, albeit from a low levels historically. Despite the current discounted bond prices.
So whilst there is a likelihood of spread widening, the magnitude will be sensitive to the depth and length of the recession, and the monetary policy response. Which in turn raises an even more important question for investors: Where in the rating tables - from CCC to BB - should their high yield investment manager be focused in 2023? Check out all High Yield Bond Investment Manager analysis inside RFPnetworks.
Key Takeaways: Caution is warranted entering 2023, however volatility could present intriguing buying opportunities • Although headwinds persist, the solid fundamental starting point should help most companies weather a slowdown and result in a persistently low default rate • Spreads could widen if a recession becomes more imminent. However, elevated yields and discounted bond prices look attractive and we believe high yield could surprise to the upside and generate coupon-plus returns.
Trading Private Credit for Bonds
High yield bonds or private credit? Investors are comparing the benefits and disadvantages of each for the current changing market environment.
Loans have received a lot of attention over the past couple of years, even before the pandemic. The view was that rates could only rise (from negative or zero territory) as inflation crept back into the system. In such an environment, the case for floating rate versus traditional fixed income high yield bonds balanced the portfolios of yield starved investors. The same mantra is still being repeated by loans managers today, but high yield bond managers are now starting to shout louder.
The simplicity of the argument to buy floating rate in a rising rate, rising inflation environment ignores the dynamics of the leveraged credit cycle. Rates may be rising, but relative to what? Interest rate floors, interest coverage, and default risk also play a role. And each of these will differ as the credit cycle rolls forward.
And at the end of that cycle when inflation is finally under control, rate cuts will start. But this usually coincides with deteriorating credit quality. So where are we today?
The universe has not stood still. Over the past 25 years, the credit quality of the high yield bond market has trended upwards with over 50% of issues now being BB rated. In contrast, the loan market has seen much more volatile moves in average credit rating, with less than 25% of issuers today being BB rated.
So as we approach the later stages of the credit cycle, interest coverage and credit quality may be a decisive factor in choosing between high yield and loans. And not interest rate floors.
High Yield Bonds have outperformed loans over the past months. But also over the much longer term. And whilst loans and private credit may be the coolest asset class in town, investors are sobering up to a world in which plain vanilla investments and liquidity have old school attractions.
ONE TO WATCH
High Yield performance in 2022 is one of those years that investors will remember. It is the year that active investment managers were put to the test.
Only three times in history has High Yield delivered 4 consecutive months of negative monthly returns. That's what's happened in 2022
Will May numbers set a new record? And are active High Yield investment managers delivering in these down markets.
Follow the latest insights from High Yield investment managers inside RFPnetworks.
Investing In Niches
High Yield Bonds are being impacted by inflation, interest rates and on the corporate level by geo-political risks. But alpha can be found in the niches.
High Yield Bonds had a tough first quarter in 2022 as investors computed the impact of 3 interconnected factors on the asset class:
Current and expected inflation, in terms of input costs associated with the production and delivery of goods, and the provision of services.
Central bank monetary policy, interest rate levels and expected rate rises. And the potential risk being discussed by multiple economists of potential policy mistakes by central bankers.
Heightened geopolitical risks in both Europe and Asia and how that could translate into supply chain disruptions impacting critical production components (such as micro chips). In addition to the outlook for commodity supply and prices across energy, metals and agriculture.
However, despite negative 1Q22 total returns for the asset class, many investment managers that read the signs well, were able to find alpha in very specific niches, and attract the attention of the professional investor community.
ONE TO WATCH
The late stage of a credit cycle can be dangerous for U.S. High Yield Bond investors. Portfolio Mangers give their views on the risks of over-leverage.
Investors are contemplating the view that we have now reached late stage euphoria in the credit cycle. If this is the case, are U.S. high yield investors at risk of being over-leveraged at the end of the longest economic cycles in history?
View all U.S. High Yield portfolio manager views inside RFPnetworks to understand the risks at play.
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