by Michael Scott, head of global high yield and credit opportunities, Man GLG.
Interest rate volatility remains high as the market continues to grapple with the trajectory of inflation as well as the likely future direction of central bank policy.
Throw in very mixed economic conditions and ongoing financial stability risks, which could curb the ability of banks to lend and support growth, and there are good reasons for investors to feel uncertain.
As an asset class, high yield is not going to provide a port in a storm. But there are still very attractive opportunities for those willing to exploit the volatility.
The backdrop
The extraordinarily quick and aggressive monetary tightening of the last 12 months has ushered in a late cycle environment for credit. Yet the effects of central bank actions have yet to be fully felt everywhere.
In fact, we estimate that less than half, and possibly only a third, of the rate hikes to date have started to be felt by the real economy. That leads us to be cautious around the growth backdrop through this year, with these fears likely to be priced into lower quality rated debt in the high yield market.
Defaults are picking up, but they are likely to be contained versus prior cycles; indeed, fundamentals are generally good, both from a leverage and refinancing perspective. Due to debt being termed out, there is no looming wall of maturities in the near future: just 10% of nominal outstanding debt comes due within the next two years.
HY v equities
It is interesting to note that, in the throes of a very aggressive rate hiking regime with unclear growth prospects, the US equity market is commanding the lowest premium for taking on equity risk since 2007.
Credit, on the other hand, bottomed last October. The resulting dispersion between the two asset classes is quite unique and suggests that, from a potential risk-return point of view, credit, and particularly high yield, could outperform equity going forward.
Historically, investing in high yield when index spreads over government bonds are above 600 basis points has provided double-digit forward average returns. That moves investors into the territory of equity-like performance, but with less risk. With the average spread in the fund today close to 700 basis points, we are optimistic about potential future returns if history is any guide.
Being selective
Although high yield risk premiums are elevated relative to equities, investors will not be best served by simply owning the market.
Around 70% of the high yield benchmark is dollars. With financial stability risks still lingering, that is problematic. We do not think the ongoing regional banking sector issues in the US are going to cause a credit crunch on the scale of 2007, but it is obvious that lending and extension of credit is going to suffer across the Atlantic.
As investors, we prefer European issuers and particularly the UK and Iberian banking sectors. Iberia is very much a floating rate mortgage market and the banks are seeing significant profitability benefits from loan repricing and lower deposit betas. Remaining in the senior parts of the capital structure also offers up a lower risk entry point within financials.
In the US we have some short positions within the regional banking sector. A large number of regional banks could be insolvent or in some form of resolution if they fell under the European regime. This is a situation that cannot be solved through the provision of liquidity by central banks. In our view, this is going to become an asset problem when bad loans come due. That will increasingly lead to weak credit creation, which could then compound the asset issue. Inevitably, this will precipitate much weaker growth in the US.
Better opportunities elsewhere
If the growth picture is concerning, so is the cyclicality – and lower quality – of the US high yield sector.
We prefer to focus on cash-generative, non-cyclical sectors in Europe, where we can take security. We favour areas like gaming where we think we are getting fundamentally over-rewarded for the strong fundamentals.
This is a sector that historically has seen top line growth even with unemployment rising, yet yields are anywhere from the low double digits to the mid-to-high teens in certain situations.
On the flipside, this year we are very light on energy, and on commodities in general. We believe that the next cycle is going to be a commodity-led, with higher inflation and higher interest rates. But these areas of the market are just not cheap enough. Given the underlying inherent cyclicality of the businesses, we will wait for better entry points.
Until then, we will continue investing in issuers with pricing power, such as healthcare and consumer staples, and in opportunities in real estate and special situations. Here we see value, relative safety, and attractive future total returns.
