The co-heads of our global high yield team explain how the asset class is standing up to current headwinds.
Read this article to understand:
- The factors driving inflation regime change
- High-yield strategies designed to add value in a rising rates environment
- The importance of monitoring leverage and expectations of default
It has been a testing year for investors, with the Russia-Ukraine conflict forcing tightening in two critical global markets – energy and food. The war has had significant spill-overs: sending inflation to 40-year highs, increasing the risk of recession, prompting geopolitical questions about energy dependency and the future of fossil fuels, and hitting valuations of risk assets.
We spoke to the co-heads of global high yield at Aviva Investors, Sunita Kara (SK) and Brent Finck (BF), for their thoughts on the prospects for the asset class in these challenging conditions.
All risk asset classes have been under pressure this year. What's the story for high yield?
SK: Like many other asset classes, high yield (HY) has experienced negative returns in 2022. The HY benchmark [Bloomberg Global High Yield Excl CMBS & EMG 2% Cap Index] is down over ten per cent in the year to date. We have had the impact of the obvious macro drivers coming through, which have contributed to drawdowns.
The Russia-Ukraine conflict, higher inflation and central bank monetary tightening have all played a part, but there has been a lot of dispersion at a sector level and by rating quality. Lower quality credits – the triple-Cs – were outperforming at the start of the year but are now underperforming, particularly in sectors exposed to higher energy prices.
BF: There are not a lot of places to hide. Inflation is hitting even the more defensive industries such as healthcare. Higher labour costs and commodity inflation are an issue across the board; the impacts have been very widespread. Energy has been one of the few comparatively bright spots, because of the underlying commodity cost move.
What about the longer-term context? We have seen comments from the European Commission suggesting energy and food prices may have been too low for the past forty years.
SK: We are currently experiencing a regime change. There will be a period of quantitative tightening, which is effectively going to mean all the structural factors that led us into a low-inflation world – energy, food and labour – are going to reverse. If we think about year-on-year changes in CPI, it is feasible the price increases we experience over the next ten years will be on average higher than they have been over the last ten.
BF: The big question is whether this is temporary or not. The world may be challenged by higher rates going forward, but it may not prove to be a long-term trend, in my view.
At a sector level, you picked out energy, but it was not so long ago that it was under a lot of pressure. Will today’s higher price regime persist, and what are the implications for HY?
BF: The events in Ukraine have exaggerated impacts on prices. We are still heavily dependent on actions from OPEC and other members of the cartel in determining energy supplies. But from a high-yield issuer perspective, we have seen more discipline recently than we had in 2015 and 2016, when the sector was under pressure.
There has been less focus on production growth and more on sustainable free cashflow and companies reinvesting in their businesses. Some elements of that tie into the ESG movement. Less capital, and sometimes more expensive capital, is being put into projects; because of that, there is not as much swing supply that can come on. That’s why we are still positive on energy and commodity prices in the near term.
If we enter a recession, there will be demand destruction and that might change the equation
That being said, if we enter a recession, there will be demand destruction and that might change the equation. But with oil over $100 a barrel and the cash cost for many of these producers significantly lower than that, there is a large cushion from a credit fundamental standpoint.
Historically, high-yield bonds tend to be highly correlated with commodity prices. Even if oil fell from – say – $110 a barrel to $80, which would still be operationally profitable, we would expect bonds to react to that lower price.
We have seen a lot of consolidation within the industry, and now we're seeing extremely high free cashflow. The demand slump from COVID-19 led to a wave of fallen angels in 2020, but a lot of these names are now returning to investment grade, so we have a number of rising stars within the energy sector.
SK: Investors can see the impact of greater discipline and balance sheet repair in how the weighting of the energy sector in the high yield market has shrunk over the past year. The sector was valued at just over $200 billion a year ago, but that number is now closer to $180 billion. That illustrates the impact of those rising stars.
How much divergence is there between traditional energy players versus those in the process of transitioning their business models and pureplay renewable energy providers?
BF: In the US, issuance is largely from traditional producers; there's not a lot of issuance from renewables companies, although a lot of them are exploring carbon capture and other new technologies. But it's not necessarily about wind farms or solar panels; that plays more into how electric utilities are producing power.
In Europe, energy makes up a smaller part of the HY market and issuance tends to be from pureplay names
SK: In Europe, energy makes up a smaller part of the HY market and issuance tends to be from pureplay names. There are a few ways to access some of the trends we are seeing on the renewable energy front; for example, via corporate hybrids, which are rated as high yield while the parent company is investment grade. It’s an area in which you need to be selective.
What about the divergence between short-duration and longer-dated bonds?
SK: From a total return perspective, short duration has outperformed broad global high yield by close to 400 basis points so far this year, which is material (see Figure 1) . On a spread basis, both markets have widened out around 200 basis points, so the outperformance has really come from duration.
Figure 1: Global High Yield versus Short Duration Global High Yield (spreads)
Source: Blackrock Aladdin, May 31, 2022
Typically, the average term in the short duration market is about 1.7 or 1.8 years less than broad global high yield. Saying that, even broad global high yield has a comparatively low duration – around four years – when compared to other areas of fixed income. As we start thinking about investment grade or emerging market debt, duration extends to six years or more.
The way in which rates have moved this year is part of a broad-based pattern. Within the trajectory of tightening monetary policy, it can pay to be shorter versus broad global high yield.
Are there any sectors looking particularly challenged?
BF: One sector that's getting hit hard is retail. It’s obviously suffering from consumers being stretched by higher energy and food prices. We have historically been underweight on the sector and remain cautious.
Pharmaceuticals has been one of the worst performing sectors this year
One of the worst performing sectors this year has been pharmaceuticals. Although investors might typically think of it as defensive, we are seeing more idiosyncratic pressure on some of the largest issuers, some of it due to corporate actions as they split their businesses up. Issues with patent expirations and litigation have contributed to some poor sector performance.
SK: From a regional perspective, there is not much difference in terms of how markets have performed. US HY is about 200 basis points wider, compared with around 190 basis points for European HY. What that does not show, however, is that there have been opportunities.
In 2022, the big driver at the end of January and into February was the Russia-Ukraine conflict. Europe has far closer economic and energy ties to the conflict, and for that reason Europe initially underperformed. But more recently we have had a catch up from the US, with the spread widening most evident in lower quality credits, from triple-Cs. US HY has much greater representation of triple-Cs than European high yield, so we are starting to see the composition effect.
Are there any areas you are seeing attractive opportunities emerge?
BF: We have found there can be an upside catalyst from names carrying out strategic mergers and acquisitions. High-yield bonds typically come with change of control clauses, which can allow bondholders to put their paper back to the issuer.
That might offer potential upside for companies being acquired. We have seen private equity and investment-grade companies buying lower-rated issuers, and there are opportunities we have been trying to take advantage of through strategic trades.
Multi-currency issuers are another area of interest for our global funds
Multi-currency issuers are another area of interest for our global funds. About one quarter of the US HY market now issues bonds in US dollars and euros (so-called reverse Yankees: debt issued by US companies outside the US), so without taking any additional credit risk, we've been able to move within capital structures.
Previously, we rotated a lot of our US dollar exposure in these multi-currency issuers into euros and are now benefiting from the recompression between those two markets.
Another theme we have had is based around credit quality. We've been underweight triple-Cs, the riskiest part of the market, and it’s underperforming. There are opportunities to pick through, but we need to be highly selective regarding which of the names we view as survivors. It is striking to see how much change is going on, for example among auto parts suppliers where the consolidation theme is playing out.
What about relative-value considerations?
BF: Yields are above seven per cent, having started the year around four per cent (see Figure 2). The current levels are more representative of what the asset class has historically delivered, although we are certainly not saying the market will not go higher from here.
Figure 2: Global High Yield versus Short Duration Global High Yield (yield to worst)
Source: Blackrock Aladdin, May 31, 2022
For much of this year, high yield outperformed relative to investment grade and emerging market debt. It’s only been in the last month or so where we have seen significant spread widening. Until this point, we have been cautious from a relative-value perspective. But now things have changed, and it’s starting to get interesting again. We expect that to continue as we move through 2022.
If you have appetite for a little more volatility, longer-duration global high yield offers more upside
Risk appetite will determine positioning; if you have appetite for a little more volatility, longer-duration global high yield offers more upside. For those more concerned about volatility, short-duration global high yield can provide a similar level of income and yield, but with less interest rate risk. Both are at relatively attractive points from an historical standpoint.
What kind of characteristics are you looking for among corporate survivors?
BF: An economic slowdown is upon us. We are looking closely at non-cyclical sectors for issuers where the top line is more likely to hold up. Healthcare, for instance, could be a case where there may not be as much revenue pressure. Success will require effective management on the cost side, but we can see a lot of these companies surviving over the long run if they are efficient at doing that.
How are rising rates impacting primary markets and what kind of pressure is it creating in terms of debt servicing costs?
SK: It is a new environment; it’s a more expensive regime for many companies who have not experienced new issue premia and these levels of yield to print debt. It's much more costly, and that's why we have had little supply.
Prior to this, we had a good three years with a lot of refinancing activity in the primary market. The maturity wall was pushed back, so there is not a huge need for refinancing until around 2025. It’s not as if we're looking at a huge number of companies that need to access the debt markets now, because so many were opportunistic and timed it.
Even those who want to carry out liability management are finding it unattractive
Clearly, given where current yields are, even those who want to carry out liability management are finding it unattractive. For example, double-Bs are yielding nearly six per cent. Those same companies would be financing themselves at less than half that level before COVID-19. Corporate treasurers will be approaching this with a different mindset; they will not wish to pay the current yield to get debt printed.
At the lower end, the triple-Cs, the yield is about 12 per cent. If a triple-C issuer were to come to the market, it would need to offer a reasonable premium; that would impact cash interest costs a lot, so that area of the market is not buoyant now.
Nevertheless, interest cover is generally still quite healthy, because of the lower yields locked in some time ago with longer-dated debt. So, from a balance sheet and interest cover point of view, we are not overly concerned. Our focus is more on the trajectory of earnings before interest, taxes, depreciation, and amortisation (EBITDA). If leverage metrics deteriorate, we expect it’s most likely to be because EBITDA is not growing as much as expected, or begins to decline, depending on the sector.
BF: One area we are watching is companies with a lot of floating-rate exposure, primarily through leveraged loans in their capital structure. This is an area where we are monitoring interest coverage ratios closely.
What about default risk?
BF: Moody's forward default forecast is still only in the three per cent range, below the long-term average, but trending up. Many companies are starting from a position of relative strength, with balance sheets in comparatively good positions.
Companies have not had much time to get aggressive in their balance sheet actions
If you think about it, it has only been about two years since the last recession, so they have not had a lot of time to get aggressive in their balance sheet actions. In some ways that is working in our favour, and the market is higher quality than it has ever been, with a bigger proportion of double-B credits. A lot of that is due to the fallen angels of 2020, but the triple-C portion of the market is smaller than it usually is.
We expect defaults to rise, particularly if there's a recession, but perhaps not to the extreme levels we've seen in the past.
Have you made any significant positioning changes to reflect the macro environment?
SK: We have already mentioned the reverse Yankee trades that have been prominent for most of this year. We started early with those.
Then we would flag the quality bias. We have been significantly underweight double-B bonds; we have now materially reduced the underweight to raise the average credit quality of the portfolio.
From a sector standpoint, we have been reducing consumer cyclicals, being mindful of a consumer-led slowdown coming through in the rest of 2022. But our investment decisions come down to reviewing individual issuers case-by case, looking at their vulnerability to cost inflation and energy cost inflation, how much hedging they have in place and so on.
In recent weeks, there have been debates on whether energy security should be prioritised, with the implication climate might take a back seat. Is that impacting how you are approaching ESG?
BF: We view the biggest risk for HY companies as default and ESG metrics can signal the probability of default. We incorporate these considerations into our analysis, looking at issuers case-by-case and whether their ESG profile might change (on a non-binding basis). Governance is obviously a big factor for us, because it can result in a lot of default risk.
ESG metrics can signal the probability of default
SK: Many of the companies we deal with are private, so issuance only involves the owner plus the creditors. These companies are not necessarily far along the journey in terms of providing transparency or even knowing exactly what to present to investors.
From my perspective, the solution involves working through the ESG risk factors.
If companies were to access the market now based on the current issue profile, how much more should investors be looking for in terms of the cost of debt?