High-yield bonds appear set for success. Their yields are attractive relative to their investment-grade counterparts; their relatively short duration will be an advantage should yield curves steepen further; the post-pandemic upswing in the economy will help the earnings and balance sheets of their issuers; and, led by the Fed, central banks appear increasingly willing to include them in their asset-purchase programmes.
We believe that taking advantage of the opportunities in this market demands a genuinely active, index-agnostic approach. That means thinking globally rather than regionally, paying attention to ‘long tail’ of overlooked issuers – and making ESG analysis integral to understanding a bond’s prospects..
A clear view, plainly stated: the high-yield bond market today looks attractive, both in standalone terms and relative to other areas of the fixed-income universe.
Relative to their investment-grade counterparts, the yields on offer in the high-yield market today are higher than they were at the height of the global financial crisis. And as Chart 1 shows, every previous occasion on which high-yield bonds have offered three times the yield on investment-grade bonds has been followed by a significant run of outperformance over the following three years.
Are markets set to follow a similar path over the coming years – one in which high-yield bonds deliver superior returns to their investment-grade counterparts? We believe they are.
The unprecedented increase in quantitative easing from central banks in 2020 pushed bond yields down and so drove investors into longer-duration and lower-rated assets in search of yield.
This dynamic played out first in government bonds and then in the investment-grade credit market. High-yield bonds would seem to be the next obvious beneficiary of this process – the next domino to fall – particularly given the US Federal Reserve’s decision to explicitly include certain high yield-rated assets among its purchases. This is an important shift: it effectively brings a more explicit ‘central bank put’ to the high-yield market, potentially lowering the risk premium that investors will demand for holding high-yield bonds in the future.
Is this already in the price? We don’t think it is. Developments like this often take years to be priced into the market. Spreads on euro investment-grade credit took almost two years following the European Central Bank’s announcement of its corporate sector purchase programme (CSPP) in 2016 to tighten to their fullest extent. This could, therefore, be a driver of returns from high yield for an extended period.
At times of cyclical expansion – such as today – investors tend to move away from government bonds and into riskier securities. Alongside this, central banks usually tighten monetary policy. The combined impact of these two forces is a rise in government bond yields and (typically) a steeper yield curve.
Although we do not believe that we will see extraordinary moves within government bonds from here, even relatively small moves in yields can have a significant impact on longer-duration parts of the fixed-income universe.
The high yield market, however, is one of the lowest-duration parts of the fixed income universe. As such, is well set up to outperform longer-duration assets in an environment of rising yields. In fact, during the two major recent hiking cycles in recent history – May 2004 to June 2006 and then from November 2015 to December 2018 – high-yield bonds delivered twice the returns of investment-grade bonds.
The global high-yield market is about a fifth of the size of the global investment-grade market. Managers of investment-grade bond funds often have the ability to invest between 10% and 20% of their portfolio in the high-yield market. Many reduced their allocations to high yield in favour of investment grade in 2020 due to the huge uncertainty caused by the pandemic. The relative attractiveness of high yield as we move into a ‘post-pandemic’ economy makes it likely that investment-grade managers will begin to allocate capital back to the high-yield markets. Given the relative sizes of the two markets, even a small increase in allocation can have a huge impact on demand and so, potentially, on the performance of high yield.
As vaccines are rolled out and economies re-open, we anticipate very strong rebound activity in economic growth in the second half of 2021. This is further compounded by an elevated savings rate alongside strong and continuing fiscal and monetary stimulus.
All else being equal, the bonds of companies in cyclical industries receive a lower rating than those of issuers in less cyclical areas. This makes sense – greater uncertainty in a company’s cashflows make its ability to service debt less certain. This also means that the high-yield market tends to have greater inherent exposure to the economic cycle than the rest of fixed-income universe. So in times of economic expansion, the high-yield market is better placed to benefit.
The factors listed above will provide a tailwind to the global high-yield bond market as a whole. But this is a broad market encompassing a wide range of risks and opportunities. We believe that rigorous, bottom-up risk analysis is needed to harness the significant opportunities available while avoiding the biggest losses.
This demands flexibility, hard work, skill – and not being constrained by inefficient indices. It also means assessing opportunities created through investor behaviour around ratings, and other considerations such as the future impact of environmental and social factors on a company. Here we expand on these critical characteristics for outperforming in the high yield market.
The top 100 issuers within the global high-yield market account for over 40% of its value. Index-led investors (which the majority of high-yield investors are, given their portfolios often contain hundreds of holdings) must focus their attention on these larger issuers who will drive the majority of the controllable relative performance. As such, these largest issuers are overcrowded and over-covered.
In contrast, companies who may only have issued a single bond, one that may account for just a few basis points of the benchmark, are simply irrelevant to index-led investors. If they are truly index-agnostic, genuinely active investors can pay more attention to this less scrutinized ‘long tail’ of high-yield issuers. When they find dislocations and compelling opportunities, their high-conviction approach means that they can invest in size.
The vast majority of high-yield bond funds and investors are segmented by region. In fact, 90% of the assets held in high-yield funds are in regional funds. Even within most ‘global’ funds, investments are rarely evaluated on a truly global basis. Instead, a ‘global’ fund is often the product of a European and a US high-yield fund being crudely welded together.
This means that most high-yield investment decisions are made exclusively in the context of the region in which they are based rather than being viewed globally. The prevalence of index-based investing means that the compositions of high-yield indices in specific regions play an outsized role in determining what is invested in. For instance, the energy sector is large in the US but small in Europe. This means that energy companies based in Europe often fall through the cracks, offering very attractive investment opportunities for global investors who can evaluate them relative to the full, global opportunity set.
Regional segmentation of high yield investors provides opportunities where bonds "fall between the cracks"
Likewise, market conditions or sector developments taking place in one region are rarely used to inform investment decisions in other regions. In Europe, for example, interest rates have been very low for a long time – so the market has developed responses to profit from this. Following this European ‘playbook’ would have allowed investors to react much more constructively when interest rates dropped in the US during 2020 by moving promptly into those areas of the market that they knew (from their experience of investing in Europe) would perform in a lower-yield environment.
Reading across from one region to another, combined with an index-agnostic and high-conviction approach, allows genuinely active, genuinely global investors to identify outstanding areas of value that would otherwise be constrained to a regional index position. Once these areas have been identified, they can then make up a much larger portion of the portfolio than a regional, index-led approach would permit, allowing the results of credit selection to shine through.
Investor segmentation allows fallen angels to consistently outperform
In addition to being segmented around regions, investors also tend to segment around credit ratings. This is most obvious in the ‘fallen angel’ bonds – those that ratings agencies have downgraded from investment-grade to high-yield. As Chart 3 shows, these tend to significantly outperform as they recover from the forced selling by their former owners: investment-grade bond funds.
A similar phenomenon also exists around the CCC-rated part of the market during downturns. Many high-yield investors (like us) tend to avoid the CCC part of the market, which tends to offer more volatility than it does value. Historically, however, this part of the market outperforms significantly at the point in the cycle where economies emerge from downturns.
One contributor to this is the fact that a number of well-managed and conservatively run B-rated businesses in cyclical areas find themselves being downgraded to CCC, purely because of the cycle. From a long-term perspective, they are not in any worse position than they were six or 12 months earlier; they are downgraded simply due to their cyclicality. This downgrading prompts selling by funds who may either have formal limits on the amount of CCC-rated debt they can own – or who would prefer not to report holding increased CCC positions at a time of market stress.
Yet in the months and years that follow these downgrades, these positions typically outperform as they demonstrate their fundamental resilience, benefit from the cyclical recovery and then see a surge in demand from investors once they are upgraded by the rating agencies.
By actively hunting in these spaces – where technical factors cause unmerited and temporary underperformance – significant opportunities can be identified and, if allocated to as part of a high-conviction approach, this can significantly contribute to performance.
Talking about ESG is nothing new in fixed income; plenty of managers pay lip service to its importance. Few, however, do anything more than pulling in some third-party ratings and base their ‘integration’ around these and some simple screening. Yet because some bond issuers are unfairly maligned by the box-ticking, one-size-fits-all approach of the rating agencies, there can be significant investment opportunities for those prepared to look a little more closely.
By incorporating ESG analysis completely into a bottom-up analysis process, investors can better understand the impact that ESG factors have on the economics of the companies that they invest in – and so on their ability to meet their financial liabilities. This much more in-depth and tailored approach allows them to find strong ESG opportunities that other investors may miss.
To take one example, Adient is the largest global producer of seats for automobiles. It is penalised by MSCI compared to those of its peers in the auto parts sector who make components for drivetrains because it doesn’t have explicitly ‘cleantech’ solutions. It doesn’t need to: after all, seats are inherently not at risk from the electrification of vehicles, and even benefit due to the higher margins available selling seating solutions for electric vehicles. This, however, is missed in a simple, one-size-fits-all ESG score. A tailored approach that takes a more nuanced view of ESG factors allows investors to identify such misunderstood companies – whose bonds may be hidden gems – and profit from them.
Jack is one of the co-managers of the Artemis Funds (Lux) - Global High Yield Bond fund and Artemis Funds (Lux)- Short-Dated Global High Yield Bond fund, along with David Ennett and Stephen Baines. Visit the fund pages for further information about the funds’ performance and current positioning.
About the author
Jack Holmes, Fund Manager, Armetis Investment Management
Jack manages Artemis’ global high yield bond strategies alongside Stephen Baines and David Ennett. Jack joined Artemis in June 2019 from Kames Capital, where since 2016 he co-managed a range of high-yield bond funds. Before that, he was an investment analyst at Standard Life Investments. Jack began his career as an economist at Cambridge Econometrics after graduating from Trinity College Dublin with a first class honours degree in economics. He is a CFA charterholder.
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