The Case for High Yield in a Weakening Economy
Q: High Yield is one of the few remaining asset classes with decent yields, but economic growth is weakening. Is the sector fraught with risk?
Andy: Fraught with risk? No! At this stage of the economic cycle, are the waters more challenging to navigate? Of course! The global economy is dominated by dovish central banks supporting loose financial conditions. High yield fundamentals remain healthy and the outlook for defaults is benign. We are not seeing any of the aggressive borrowing behavior we saw prior to the 2008/2009 recession. While we’re seeing a synchronized deceleration in the global economy, it should hit a bottom in the first half of 2020, followed by slow economic growth in most advanced economies throughout next year. High yield spreads are relatively tight, and certain high yield sectors, such as energy, are weak. We expect market volatility tied to trade war headlines, although volatility creates both risks and potential opportunities. Barring any material change in our macro outlook, the picture is supportive for a selective investment approach to the asset class. Longer term, there’s a strong case for an allocation to US high yield and global high yield.
Q: What are the major risks in high yield?
Ken: An escalation of trade tensions is the one risk we are closely monitoring, as a full-blown trade war contagion would affect personal consumption, hurt the service sector, and put even more pressure on manufacturing. In this scenario, we would expect a spike in premia. Of course, a broad, comprehensive settlement of the US-China trade war, which we are not expecting, could lead to stronger economic growth in 2020, in which case government bond yields would rebound. The higher coupons and shorter average duration of high yield bonds should provide more downside protection than investment grade corporate bonds or government bonds, which would be more severely impacted.
We are cautious on retail and energy, particularly exploration-and-production and energy services companies. Both industries have a significant number of companies under pressure. We don’t see an easy solution for many distressed energy companies. The retail segment continues to struggle with secular changes. Still, the retail sector is one of the best-performing sectors year to date. We always remind our investment team that to perform well over time an investor needs to be willing to sell the assets they have loved and buy the assets they have hated.
Q: What is the outlook for defaults?
Andy: We think they are going to increase, albeit modestly. The distressed ratio, which is the share of high yield bonds trading at spreads larger than 1,000 basis points over treasuries, shows about 6% of high yield bonds by market value are trading at distressed levels, and about half of that is energy. These numbers are relatively low by historical standards. The good news is that surveys conducted by the Federal Reserve and the European Central Bank show that, on average, banks are not significantly tightening standards applied to corporate loans. This is another positive indicator for defaults.
Q: There is increasing dispersion between the returns of the lowest rated bonds (CCC) versus higher rated bonds (B, BB). Is this a warning sign for the broader high yield market?
Andy: Given the underperformance of CCCs, one would think that CCCs would be a great place to look for bargains! Unfortunately, when you look closely, you find that many CCCs are weak credits in troubled sectors, particularly energy. Because so much of the underperformance of the CCC portion of the market reflects sector-specific risk, we do not think that CCC performance foreshadows major high yield credit problems. In a high dispersion environment such as the current one, idiosyncratic price drivers are key market movers. Sector and security selection can create more value when bond prices and yields move in response to idiosyncratic factors.
Q: Where are the opportunities in global high yield?
Ken: When considering global high yield, US high yield remains the largest component of the global high yield market, at 60%, while European high yield and emerging markets corporate high yield represent around 20% each. Looking at the relative annual performance of those three components of the global high yield market, US high yield is rarely the winner. A global strategy can allow a manager to pivot from one submarket of the global high yield market to another in search of return potential. For example, fundamental and technical trends have been decoupling this year in both the European Union and the US, with opportunities emerging in Europe. Fundamentals appear healthier in Europe than the US, with use of corporate leverage lower. This is despite weak earnings growth for European companies. The European high yield market is also more defensive than the US, with more BBs and fewer CCCs. In addition, Europe can offer interesting investment opportunities in “rising stars” – high yield companies with the potential for upgrades to investment grade. In Europe, this group includes certain subordinated peripheral issuers.
Q: High yield is more vulnerable to liquidity risk than other fixed income sectors. How should investors think about this?
Andy: So far this year there has been no material deterioration of liquidity conditions in high yield markets, but liquidity strains could arise in a market sell-off, and it is worth noting that the EU is typically less liquid than US. In our opinion, it is key for high yield investors to balance their portfolios with a mix of liquid and less liquid holdings. Active managers have tools at their disposal to deal with a liquidity crisis, including liquidity buffers and constant monitoring of market and investor liquidity.
Q: Is ESG a factor in the high yield sector?
Ken: We are getting more questions from clients about high yield and ESG, and we expect interest in high yield ESG strategies should increase. Amundi has made a large investment in ESG and has a large team of ESG specialists. We consider ESG factors as part of the fundamental analysis we conduct on each security we own.
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