Commentary: Seeking attractive, through-the-cycle returns in high-yield multicredit

Institutional investors continue to turn toward high yield for its potential to offer attractive risk-adjusted returns in a continued slow-growth, low-rate environment. However, not all investors understand the full depth and breadth of opportunity in the global high-yield market, which has experienced tremendous growth and evolution since the 2008 financial crisis.

From a relatively one-dimensional asset class defined primarily by subinvestment-grade U.S. corporate bonds, the global high-yield universe today is a more than $3 trillion market, as calculated by Credit Suisse, which includes more than 3,000 issuers across four core subclasses: corporate bonds and loans issued by companies in the U.S. and Europe.

While many investors continue to bring a compartmentalized, single-asset mindset to investing in high yield — for example, hiring one manager for U.S. bonds, another for loans and another for European bonds — we see potential benefits to considering a multicredit approach. This approach gives investors' high-yield allocation more flexibility, improving the ability to capitalize on opportunities across the global high-yield markets as they appear throughout the credit cycle.

In addition to the potential for attractive yields in a low-rate environment, a multicredit approach to investing can offer the following benefits:

• Diversification within a single portfolio across high-yield assets — including corporate loans and bonds, collateralized loan obligations and distressed credit — and geographic regions;


• A single point of access to global corporate credit beta;


• Flexibility to move among asset classes and regions;


• Ability to respond in real time to short-term relative value opportunities that arise on the back of technical factors such as geopolitical events and fund flows;


• Reduced governance and the placement of tactical allocations into the hands of one high-yield manager; and


• Opportunities to dampen portfolio volatility.

The large opportunity set represented by the four core high-yield subasset classes is, in and of itself, a compelling reason to consider a high-yield multicredit portfolio.

At $1 trillion-plus, the U.S. institutional loan market has nearly doubled since its 2011 post-crisis low. The U.S. bond market has expanded by nearly half, from $1 trillion in 2009 to roughly $1.5 trillion today. In Europe, the bond market has grown more than four-fold to €466 billion, Credit Suisse data show, and the loan market, while stunted by the crisis, has expanded more than 10% since 2014 to €167 billion.

The overall growth and maturation of global high-yield credit has created an investible universe that looks much different from the market of a decade ago and allows portfolio managers to select their best investment ideas throughout the credit cycle while also maintaining a highly diversified pool of credit.

At the heart of the multicredit approach to high yield is the recognition that, while U.S. and European corporate credit, whether bonds or loans, tend to be highly correlated and share similar risk/return profiles, these markets historically have been punctuated by periods of dislocation, during which technical factors or risk flare-ups have caused any one subasset class to outperform or underperform at a given time. "Top-down" pricing inefficiency during such periods, often disproportionately sentiment-driven, can cause assets to become mispriced relative to underlying fundamentals and other subasset classes.

By investing across the entire universe of global high yield, a manager focused on fundamental analysis and bottom-up credit selection can uncover excess value, often without compromising on asset risk or quality. Similarly, a manager with a holistic view of these markets might be able to identify opportunities in related asset classes, including CLOs and distressed credit, and adjust allocations in an effort to maximize potential risk-adjusted returns.

An analysis of post-crisis global high-yield returns suggests a strategy with the flexibility to shift between U.S. and European loans and bonds can outperform relative to a single-sleeve strategy, given that value tends to shift between these asset classes over time. Between 2011 and mid-2017, for instance, U.S. high-yield bonds outperformed other high-yield subasset classes three times, while European loans and bonds each outperformed twice.

The ability to reallocate capital during market dislocations proved its value during the energy sell-off in 2015, when the U.S. high-yield bond market, with greater exposure to energy than its European counterpart, was broadly down despite the fact many issuers were benefiting from lower commodity prices. Within U.S. high yield, bonds had significantly more exposure to the energy sector than loans and thus offered significantly better return potential when the market recovered.

Managers with the ability to look across these markets were in a position to capitalize on this dislocation of price and underlying value, and those who shifted into U.S. high-yield bonds ultimately benefited a year later when U.S. bonds went on to outperform the other core subasset classes of global high yield.

Timing a sell-off or identifying an entry point into any market can be very difficult, as evident from recent risk flare-ups — the 2011 eurozone crisis, the "taper tantrum" of 2013, energy's swoon and the Brexit vote — during which the entry point came and went relatively quickly. As follows, it is important that investors are positioned to reallocate in as close to real time as possible.

The same flexibility that allows portfolio managers to capitalize on opportunities as they arise can help keep volatility at bay. While often a result of the growing influence of short-term investors in global high yield — a new and often sentiment-driven element that investors must consider — volatility can also stem from macroeconomic, geopolitical and other technical factors.

When looking at the global high-yield markets today, fundamentals continue to look stable and leverage ratios remain reasonable. But the reality is that several issues — ongoing Brexit negotiations, sector-specific risks in the U.S. around energy, retail and health care, and geopolitical events across multiple regions — represent potential volatility triggers.

In this environment, an integrated multicredit high-yield strategy can be particularly valuable in providing portfolio managers with the flexibility to pivot to those regions or subasset classes that they believe offer the best relative value at any given time.

David Mihalick is head of U.S. high-yield investments for Barings LLC, Charlotte, N.C. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.