A case for high yield in a rising rate environment

Last year, the fixed-income markets saw considerable volatility as participants debated whether quantitative easing was about to end — this was answered in December as the Fed began its tapering program. At the time of writing, U.S. growth dynamics remain favorable and with greater visibility on fiscal policy, there is risk that U.S. growth could surprise on the upside.

However one thing remains clear: QE will only end if the economy is growing. If growth is less than expected, there will be no tapering and we will see the continuation of demand for high-yielding assets. However, if growth surprises to the upside and tapering does happen, markets will focus on how high yield behaves in a rising rate environment. The good news is that in a rising rate environment, high yield usually outperforms other fixed-income asset classes as long as there is economic growth and default rates remain subdued.

While short-term interest rates are expected to remain low, any signs of growth are likely to be accompanied by a steepening yield curve and the 10-year Treasury returning to 3.5% if not higher. So the question would be: How would that affect high yield? In fact, high-yield returns are usually negatively correlated to Treasury returns, as are equity returns. The biggest driver of high-yield returns is real gross domestic product growth.

The reason for this is that high-yield companies, especially those lower down the rating scale, need economic growth to grow into their capital structures. In some cases, economic growth can lead to strength in the equity markets and this increases the prospects of initial public offerings for private companies and also gives management of investment-grade companies an incentive to buy smaller companies that are often high yield. This is the reason high yield also has one of the highest correlations to equities within fixed income. Unsurprisingly, positive expectations for GDP growth would support the asset class.

There is a strong case for looking at high yield from a global perspective.

The European high-yield market (British pound sterling and euro) has seen its face value grow 275% in the past five years, while emerging markets high yield has grown 178%. This compares to a 70% growth in U.S. high yield. As of today, the combined European and emerging markets high-yield components represent $670 billion vs. $1.241 trillion for U.S. high yield. Thus expanding a mandate to include non-U.S. high yield increases the opportunity set by 54%.

A common argument against investing globally is that non-U.S. domestic markets are illiquid and don't offer sufficient incremental value. However, an analysis of excess returns since 1993 disproves this claim. As can be seen in Figure 1, both emerging markets and European high yield have produced better excess returns and risk-adjusted excess returns than the dollar market, although both have greater volatility.

In addition, the increased size of passively managed exchange-traded funds has resulted in an environment where we find there is little differential in liquidity between Europe and the U.S. on a day-to-day basis. Emerging markets high yield generally has been less liquid, but that differential ought to lessen as the asset class gains greater acceptance.

The global high-yield opportunity can be seen even more clearly when one analyzes excess returns by market. As shown in Figure 2, over a period of 15 years, U.S. high yield has only provided the best excess returns four times and, with the exception of this year, those periods of excess return for U.S. high yield over euro/sterling and emerging markets high yield has been during periods when risk is selling off. Thus, by excluding non-U.S. markets, one is likely to underperform over a cycle.

An analysis of high yield can't go without considering its attractiveness vs. equities.

If we look at the Sharpe ratios of a number of asset classes since 1993, it is clear equity has not been a top performer either in absolute- or risk-adjusted terms. If one is not convinced about the upside to equities given below-average economic growth and wants or needs a fixed-income stream with a limited impact to rates, high yield — particularly shorter duration high yield — makes a lot of sense as part of an equity bucket.

Credit fundamentals for high yield remain strong. The current global high yield default rate is 1.8% compared to 25 year averages of 3.9% with estimates for 2014 between 1% and 3%. This continued low default rate is driven by economic growth, limited refinancing risk and better-than-average credit ratios. This suggests that for the coming 24 months there is unlikely to be a credit related crash in high yield.

High carry, negative correlation with rates, and positive correlation with economic growth combined with low default rates will make high yield attractive vs. many other fixed-income investments. The relative value vs. equities also remains attractive.

The non-dollar portion of the high-yield market has grown rapidly and provides an opportunity to invest in a far wider opportunity set than was previously available in high yield, allowing exposures to different economies and industries therefore by expanding out of a U.S. domestic mandate, risk-adjusted returns can be enhanced.

David Newman is senior partner and head of global high yield at Rogge Global Partners, London.