By Konstantin Leidman, fixed income portfolio manager at Wellington Management
Investors often tend to focus on the short term when it comes to investing in the high yield bond market — approaching the asset class tactically rather than with a long-term mindset.
In reality, high yield investing should be a marathon rather than a sprint. Success isn’t about who records the best time for the first mile of the race, but rather about who completes the course and crosses the finish line first.
Above all, this means managing downside risks given that defaults could lead to permanent destruction of capital. There are a few key ways that high yield investors can mitigate risk.
Incorporating sector and region views is one way investors can spot the signs of potential bubbles and avoid areas that are at higher risk of default. One such theme to avoid is AI.
Overexuberance is a danger signal
It is vital to have a healthy scepticism when other investors become overly excited. High yield investing can have an asymmetric return profile — investment in individual credits can be rewarding, but there is the potential for permanent loss of capital if a company defaults.
AI — which has seen significant levels of investment and above-trend capex— is an area with potential for another bubble to form. Should the tide turn on demand, high yield investors could find themselves exposed to default risk in issuers that have significant exposure to the AI theme.
History has shown that during downturns, defaults tend to be concentrated in sectors undergoing increased capital supply and investment, such as the shale oil crisis in the 2010s. In the run-up to this event, we saw higher profits and prices in the sector lead to increased capital investment and competition.
The sector was ultimately exposed when demand slowed. The dotcom bubble of the late 1990s is another example that shows market enthusiasm can often come with unintended risk.
While AI is creating some compelling new opportunities and there may well be long-term winners, predicting the winners and losers of the AI boom is far from straightforward given the wide distribution of outcomes, and there will inevitably be instances of misdirected capital.
It is also worth remembering that while the valuation premium inherent in AI-related stocks creates a significant opportunity cost for equity investors, we have not seen this trend translate quite as clearly to the high yield market.
Instead, it is worth being wary around the significant levels of above-trend investment and capex that may translate to a higher risk of defaults. For now, investors should be cautious on companies with high exposure to the AI theme, such as technology hardware companies.
Finding high-quality in an inefficient market
The high yield market is highly inefficient at pricing default risk. Taking advantage of potential mispricings while minimising default risk requires significant fundamental, bottom-up credit research to uncover the highest-quality companies in terms of their underlying economic fundamentals.
Equally, it means avoiding those companies with a risk of permanent destruction of capital, as well as the sectors and regions where defaults are likely to be concentrated.
Those looking to uncover high-quality issuers should prioritise seeking out companies with proven competitive advantages or moats. While investors may be cautious on companies that have high levels of exposure to the AI theme within the technology sector, for example, there are still a number of opportunities in payment providers and software services providers with strong competitive moats like the high expense of changing providers.
Alternatively in the automotive sector, investors should be cautious on auto manufacturers where there has been a large expansion in competition and new entrants to the market.
Nevertheless, it is worth being selectively optimistic about the potential performance of auto suppliers, which often have high barriers to entry. Many of these companies have deeply integrated relationships with original equipment manufacturers (OEMs) and there are financial, technical and regulatory hurdles associated with switching suppliers, particularly in the middle of an auto production cycle, which can last upwards of 10 years.
Heightened default risk in 2025
We are currently navigating what could be a more volatile environment for markets. Provided investors avoid a default cycle — which is the base case — high yield has significant appeal for those who can undertake the necessary bottom-up fundamental research and implement a disciplined sector and country framework.
This is crucial in order to avoid issuers and sectors to have a higher risk of default, such as issuers with significant exposure to the AI theme.
