Konstantin Leidman, a portfolio manager on the Wellington Global High Yield Fund, discusses default levels, interest rates and the impact the current macro environment is having on his investment process
Should investors be worried about defaults rising in the high yield market, or feel comfortable they are getting compensated for the perceived higher risk of these companies?
With macro conditions still deteriorating, we anticipate a marked rise in defaults. To date, however, we do not believe we will see a full-scale default cycle. Instead, we expect the rise in defaults to remain broadly in line with historical averages and well below past recessionary peaks. While, currently, we believe investors don’t need to be overly worried about the overall rise in defaults, we think security selection will become increasingly critical.
Will higher interest rates bite, and wean out ‘zombie’ companies kept alive by the cheap money seen since the financial crisis?
Many issuers have bolstered their balance sheets since the onset of Covid, and high-yield issuer fundamentals held up fairly well to date, despite higher input costs. The limited number of issues maturing through the end of 2024 further minimises the chance of defaults. However, we expect companies will face continued margin pressure in the next six to 12 months as costs might not be as readily passed on to the weakening consumer. This again points to the importance of identifying likely winners and losers.
All in, borrowing costs are significantly higher, further cutting corporate free cashflow generation. In this environment, we are focusing on the core of our philosophy, which is picking companies that we believe will outperform over the longer term. In particular, we look for issuers that are generating free cashflow and/or have a sustainable competitive advantage relative to peers. We believe such quality credits can outperform in the event of further financial dislocations or a meaningful increase in defaults.
How is your process influenced by the macro environment?
The current macro environment is an important factor in determining how we position our portfolios. While the pace of inflation continues to decelerate, it is unclear where it will settle. Labour market conditions and wage growth will continue to influence the Fed and other central banks. In addition, the recent banking turmoil means that tightening lending standards are likely to become another area of focus.
And while consumer demand has held up well till now, the support provided by excess savings may run out in 2023. All this leads us to believe there is a reasonable likelihood of a mild recession, with a growing tail risk of a more severe slowdown. Given this backdrop, we are positioned moderately defensively. We anticipate further bouts of volatility that will present opportunities to tactically increase risk at more attractive valuations.
Konstantin Leidman is a portfolio manager on the Global High Yield Fund. The Global High Yield Fund offers investors an actively managed high yield portfolio, investing typically in 100-150 issuers diversified by sector and issuer. The fund focuses on fundamental bottom up credit research, emphasising an issuer’s ability to generate free cashflow, which we believe will allow them to outperform over the long term. Through a time-tested investment process, the portfolio aims to deliver clients the desirable asset class characteristics of high yield: total return, income, and diversification
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