Sponsored article: Eugene Philalithis looks at risk assets as the reflation narrative gathers steam. Against this backdrop, he discusses why high yield bonds – particularly within Asia – offer an attractive opportunity for income-seekers.
Key points
- We have been selectively adding to riskier assets like high yield over recent times, whilst reducing investment grade bond exposure.
- Low duration, improving credit quality and a positive downgrade-to-upgrade ratio are some reasons we favour the asset class, particularly within Asia.
- Key risks we are monitoring are rising government bond yields, high leverage, high issuance levels and negative convexity.
High yield bonds have been a significant driver of performance across our multi-asset income strategies over the past six months. However, our decision to maintain our relatively high allocation is not based solely on its ability to deliver return as there are several recent developments that have made high yield bonds a more attractive and reliable source of income.
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For one, it is a low duration asset class, which makes it more resilient to interest rate risk than investment grade bonds. Even more so than some large-cap equities which tend to exhibit a high sensitivity to interest rates due to forecasts for them to deliver long-term stable cash flows.
This is important as we have been maintaining a low sensitivity to interest rates versus history, due to the risk of rising real rates on the pay-out of debt instruments and the consequent impact on fixed income investments, including high yield bonds.
Furthermore, the credit quality within the high yield investment universe has improved significantly, providing us with a larger number of securities that we are comfortable investing in.
One reason for this improvement is the increase in “fallen angels” (companies whose credit rating has been downgraded but have incentives to improve their credit quality to re-gain investment grade status, given the yield gap between investment grade and high yield).
US high yield ratings breakdown improving
Finally, January and February saw no defaults, which suggests that default rates have peaked and are now rolling over. Recovery rates amongst issuers are also better, in addition to which we have seen a surge in pre-negotiated bankruptcies.
These tend to boost recovery as restructuring takes place sooner and companies can emerge from bankruptcy more quickly. Finally, looking at the US and Europe in particular, the ratio of upgrades and downgrades has turned a corner, with 88 upgrades and 49 downgrades by Moody’s year to date. This is impressive considering it took five years for the ratio to turn positive after the global financial crisis.
Are markets overheating?
That being said, high yield bonds have come under greater pressure due to high global debt levels caused by pandemic-induced borrowing, as well as steeply rising government bond yields and rates volatility in the US. Although leverage levels are at all-time highs, we would argue that with interest coverage back down at 2010 levels – and high cash-to-debt figures amongst issuers – these do not pose an immediate risk.
The team has also been paying attention to high levels of triple-C rated bond issuance (25% in January 2021), which can usually be taken as a sign of overheating markets.
However, issuance proceeds have been concentrated on refinancing activities or productive capex (bond-holder friendly over time) rather than dividend recap issuance and M&A (less favourable to bond-holders).
With the share of triple-C rated bonds as a share of the overall high yield index at the bottom of its historical range, and overall index quality improving, the team continues to maintain a constructive outlook on the asset class. The main risk comes from a potential hike in real rates in response to inflation. However, in line with our Global Macro & SAA team, we believe tighter funding conditions are more of a medium-term risk, and more so in the US than in other markets. In the meantime, US monetary policy will remain highly accommodative, supporting our preference for high yield over investment grade bonds.
With this in mind, the team is cognisant that majority of return coming from high yield is made up of carry, i.e. the fact high yield is trading at premium, and that further capital upside is limited. As the percentage of the index that is currently trading above call-price is at all-time highs, this increases the likelihood that high yield bonds will be called by issuers and refinanced at lower spread and coupon levels, meaning investors won’t earn the expected return if they held to maturity.
Furthermore, call activity is more likely with improvement in credit fundamentals, continued positive rating migration and investor demand—all of which has been taking place. So, while we remain constructive on the asset class, we will revisit the position if we see these credit fundamentals and technical deteriorate.
Identifying key opportunities
Although the team is positive on high yield overall, we believe that average high yield valuations are largely already pricing in at fair value. Thus, rather than ‘chasing yield’ at all costs, the team has been actively trying to identify those opportunities that offer a more attractive cost-benefit trade-off.
High yield spreads continue to tighten
Once more, Asia as a region has become our preferred source for high yield, despite recent underperformance. Our preference for low duration is one reason we maintain our bias as Asian high yield offers a lower duration profile than other regions. Given recent rises in yield have been driven by greater inflation and growth expectations, a low duration profile is attractive for the longer term.
Credit spreads between Asia and the rest of the world have widened recently, as shown in the above graph. The widening gap is driven by credit spread compression in the US and Europe while Asian credit spreads have remained stable.
This can be explained by decreased investor confidence due to slowing Chinese credit growth, issuer specific stress and property-market related policy issues, which we do not view as a systematic risk for Asian high yield.
Rather, we consider recent monetary policy in China to be ‘countercyclical tightening’ rather than ‘over-tightening’. Granted, more clarity will be required on the policy response to credit stresses within the Chinese property sector to turn onshore investor sentiment more positive; however, January double-A issuance data, which is correlated to Asian high yield defaults, provided reassurance.
These developments support our confidence in the asset class, where spread and yield continue to be attractive versus developed markets. For this reason, we are maintaining our allocation Asia high yield, which is our largest regional high yield allocation.
Eugene Philalithis is Fidelity Multi Asset Income range portfolio manager.
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