High yield managers are excited about BB-rated debt – much of which is issued in Europe, finds Piyasi Mitra.
With interest rates rising, the risk of default among companies paying higher interest rates on their corporate bonds increases. This is particularly the case for issuers in the high-yield segment, where rates are currently in the 7-9% area.
But there is a window of opportunity for investors in the higher-quality portion of BB-rated firms, according to some fund managers. Investors do not need to sink into the CCC-rated area, which is more risky.
Mark Benbow, high yield portfolio manager at Aegon Asset Management, says the rising interest rate environment has “turned the high-yield bond market on its head”, meaning investors can now find excellent deals in better-quality companies.
Benbow says investors searching for yield have for some time had to accept low yields on corporate bonds, no matter the risk profile. This saw them looking at riskier parts of the market for better income.
“For years, investors have faced the reality of lending to corporates at ever-falling yields,” he says. “Now, the high-yield market is living up to its name. As rates have shifted higher, yields on high-yield bonds continue to increase, even in the higher-quality part of the market.”
Low-interest rates in recent years kept defaults relatively low. But issuers are now forced to borrow at very high funding rates, notes Benbow, which are “proving painful” for BB-rated companies.
“…the high-yield market is living up to its name. As rates have shifted higher, yields on high-yield bonds continue to increase, even in the higher-quality part of the market”
Yet many of these companies, he says, are high quality with “compelling” long-term total return potential, despite the lower rating.
“Over the last couple of years, yields have risen significantly for the BB part of the ICE BofA Global High Yield index. In fact, the current funding rates for newly issued bonds are even higher as the index yield includes many short-dated bonds that don’t earn all that much more than risk-free.”
For new, long-dated funding, the reality is “painful” for companies as they face higher financing costs. However, investors gain from the higher coupons.
“In this environment, there are attractive opportunities to add exposure to higher-quality companies within the BB segment that offer high coupons and compelling long-term total return potential,” says Benbow.
The coupon on Electricite de France is 9.125%. Cruise operator Royal Caribbean pays 8.25%. These are among bonds that Benbow has added to the Aegon portfolio. Ford is another, paying 7.2%.
He says it’s “a great time” to be a high-yield bond investor. You don’t need to chase lower-rated or CCC risk to earn large returns anymore, and there is a “clear transfer of wealth” from equity to bondholders.
“If we stay in a higher-for-longer rates environment, we are quite happy to keep lending to companies at these levels. At some point, yields will fall again, but for now, the ball is back in the high-yield market’s court, providing investors with attractive income and total return opportunities.”
Amid rising interest rates and record bond issuance, T Rowe Price launched the T Rowe Price Global High Yield Opportunities Bond Fund last year.
The fund has exposure to the US high-yield market – the world’s biggest sub-investment grade corporate bond market – but also targets a 50% weighting in European and emerging market corporates.
Michael Della Vedova, who manages the fund, says: “Amid bank failures, it has been challenging for companies to obtain debt financing, but these conditions follow a period of record issuance in 2020 and 2021. Issuers could extend maturities out – with the bulk of the maturity walls of issuers coming after 2025 – indicative of broadly strong balance sheets.”
“The refinancing wave of 2020-2021 indicates most firms have healthy cash levels relative to debt on their balance sheets. Borrowing at meagre rates for a long time also allowed them to extend maturities”
Recent interest rate hikes, inflation and low growth have overshadowed credit risk concerns for investors. But this is likely to reverse as investors pay more attention to the strength of company balance sheets, say Della Vedova. Slowing growth will likely put the spotlight on companies’ ability to cover rising interest costs.
“The refinancing wave of 2020-2021 indicates most firms have healthy cash levels relative to debt on their balance sheets. Borrowing at meagre rates for a long time also allowed them to extend maturities, so many companies don’t need to issue bonds this year.”
Della Vedova adds that it’s important to remember that companies tend to have debt with varying maturities spread over multiple years, so the impact of the rise in interest rates is not immediate – it’s spread over time.
Sectors shining
Della Vedova finds value in European cable operators – an attractive industry in terms of valuations and supported by long-term trends in media consumption and stable, recurring revenue business models that are important during slow growth. The fund is also overweight to high consumer spending areas such as entertainment and leisure.
In a similar way to Benbow, Kyle Kloc, senior portfolio manager at Fisch Asset Management, recommends investors opt for higher-quality bonds and avoid “very low ratings”, like CCC bonds.
“We are underweight cyclical sectors owing to the recessionary outlook, and overweight industries that are better able to withstand such scenarios – and in the high-yield segment, we include energy and metals,” says Kloc. He adds that he sees potential in industrial metals – especially the likes of copper mines, given the e-mobility megatrend that ensures structural growth in demand.
Automaker Ford is a holding for the Pictet-EUR Short-Term High Yield Fund.
So, too, are Telecom Italia, Altice France, Softbank and United Group, revealing demand for technology-media-telecom (TMT) issuers.
The TMT sector is a defensive choice in making the portfolio recession-resilient, says Prashant Agarwal, senior investment manager at Pictet Asset Management.
“We look for positive catalysts such as Altice France and United Group engaging in asset sales transactions to repay some of these bonds partially,” he adds.
“Softbank has enough liquidity to repay the shorter bond maturities that we hold in the portfolio. Telecom Italia is the subject of discussions that could see their ownership change, but we expect our bonds held to be repaid or refinanced.
“Ford is a rising star, and we stand to benefit if the bonds are raised to investment grade.”
Gerhard von Stockum, co-portfolio manager of the Global High Yield Fund at J Safra Sarasin Sustainable Asset Management, says the fund’s holdings in energy continue to benefit from supportive oil prices: “While our overweight position in financials cost us a bit as debt collectors suffered after poor results and cautious near-term guidance, these bonds have started to change momentum, and this sector remains well positioned to benefit from weakening economic conditions.”
“Ford is a rising star, and we stand to benefit if the bonds are raised to investment grade”
The fund’s top holdings include a leading European recycler with “top ESG credentials”, specialised energy players, senior debt in an improving European bank, a US-based health insurance provider, a prominent departmental store operator and a diversified Chinese conglomerate with “marquee international assets”.
Europe versus the US
At T Rowe Price, Della Vedova points out the importance of Europe to high-yield bonds as a means of managing risk. Europe has higher credit quality than the US, with more BB-rated companies – 67% in Europe versus 50% in the US.
There is less exposure to traditionally cyclical industries such as energy or metals and mining, and fewer companies rated CCC or below – 5% in Europe versus 11% in the US.
As of March 31, 2023, North American issuers comprise 60% of the global sub-investment grade credit market, with European issuers accounting for 24% of the broad market and emerging market issuers at 17%, Della Vedova notes.
A Neuberger Berman analysis showed that when spreads between corporate bonds and government bonds were at 500 to 600bps, like now, investors have historically generated a positive total return – from coupons and prices – 81% of the time over a two-year investment horizon.
“We view the yields on offer today with spreads over 500bps as an attractive entry point despite uncertainties,” says Simon Matthews, senior portfolio manager, non-investment grade credit, Neuberger Berman.
Across high-yield portfolios, Matthews prefers shorter-duration and higher-quality names, with a bias towards European high yield depending on the issuer. This is because the fundamental backdrop looks better than expected.
While further rate rises would impact the cash price of corporate bonds and performance, Matthews thinks it is less of a factor in the current rate cycle.
“The average duration of the high yield market is on the low side – at 3.2 years in the case of European high yield – making the impact more marginal compared to longer-duration investment grade or government bond asset classes. With a yield-to-worst of 7.8%, we would need to see a material movement in rates or widening of credit spreads to result in negative total returns.”
Kloc at Fisch Asset Management explains that shorter durations in Europe, and therefore lower sensitivity to rising interest rates, also favour long-term investments in euro high-yield bonds.
“With a yield-to-worst of 7.8%, we would need to see a material movement in rates or widening of credit spreads to result in negative total returns”
“Only in terms of liquidity is the US market at an advantage in the event of market stress,” says Kloc.
Dos and don’ts
The year-to-date performance of the Pictet fund has been “strong” in absolute and relative terms, says Agarwal, adding that market conditions have helped investors to identify the stronger firms. Avoiding defaults is a key role for asset managers’ credit analysts carrying out bottom-up research.
Paul Benson, head of efficient beta at Insight Investment, says investors should recognise that US corporate high-yield and the S&P 500 have produced similar returns over recent years, with high-yield bonds offering 40% lower volatility than equities.
“Only in terms of liquidity is the US market at an advantage in the event of market stress”
“Global corporate high-yield has outperformed MSCI World and MSCI ACWI this century,” he points out.
Benson adds that the end of quantitative easing has dual implications.
“Firstly, greater cross-sectional dispersion amongst companies – separation between winners and losers means a higher potential for alpha for quantitative and fundamental active investors,” says Benson.
Secondly, he says, “range-bound markets” favour the high contractual income of high-yield bonds over equities.
Kloc adds that funds selectors ideally will select managers experienced in multiple credit cycles with sufficient research resourcing. “Understanding a balance sheet is not enough – it is important to have the experience to interpret patterns of firms and management teams to understand how an issuer will react to evolving markets.”
Emerging edge
Von Stockum of J Safra Sarasin considers selecting oversold emerging market issuers as “good alpha opportunities” as divergence highlights the benefit of diversifying exposure to macroeconomic forces.
Ed Harrold, investment director, fixed income, Capital Group, says “encouraging” returns in 2023 from the firm’s Global High Income Opportunities Fund came as both high-yield and emerging markets generated “strong income”. The fund offers a diversified exposure across local and hard currency sovereign and corporate bonds, and Harrold sees opportunities in local currency debt within emerging markets, partly due to sizeable real-yield differentials relative to developed markets which should protect from volatility.
The most value lies in Latin American countries such as Mexico and Brazil, where, Harrold says, there were early interest rate hikes to curb inflation and support exchange rates. The Brazilian real and Mexican peso stand out for being among the few currencies that strengthened against the dollar last year.
“Investment-grade issuers remain rich relative to similarly rated developed market corporate bonds, whilst cheaper valuations in the high-yield part of the market reflect stress with many lower-rated sovereigns close to, or already in, default situations. Hence, it is important to look through market-level valuations signals and take a bottom-up approach to building portfolios,” says Harrold.
Owning high-yield bonds ahead of a potential recession might make some investors uneasy, but for those with a time horizon beyond one year, investing in bonds with current yields of around 8% has historically offered solid returns, suggests Harrold.
“A cautious approach is appropriate in the near term, and the value lies in cash-generative companies less impacted by a potential recession, such as BB-rated pharmaceutical and cable companies.”
Steve Logan, high yield portfolio manager, PGIM Fixed Income, says he is cautiously positioned on cyclical sectors such as chemicals and autos and overweight on industries such as telecom and grocery retailers.
The fund is also exposed to sterling high yield, which remains relatively cheap as it recovers from the sharp sell-off seen after the UK mini-budget last September.
Yields are increasingly attractive on an absolute basis, and spreads are currently above the historical average, unlocking value for investors with longer time horizons, he says. In the event of stagflation, spreads and rates have already repriced to some effect – cushioning some of the blow.
In contrast, a recession could coincide with a rate decline, offsetting some volatility in credit spreads.
“If rates and spreads move sideways, the sector should generate attractive income, an outcome where rates remain near their peaks, and credit spreads contract may enhance the sector’s total return potential,” says Logan.
He cites the example of ‘reverse Yankee’ issuers – US-domiciled issuers who issue debt outside of the US in currencies such as sterling or the euro.
“Although the bonds have identical credit risk, the spread differential is driven by a combination of a lack of resources to analyse the breadth of US issuers – prompting many European investors to avoid the opportunity set – and lower liquidity levels in Europe,” says Logan.
The firm’s 2022 analysis of ten debt issuers in a range of structures in US and European markets revealed that euro offerings were an average of 181bps wider, with some premiums reaching as high as 271bps.
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