The income case for quality high yield

Phil Milburn & Donald Phillips

With rising concerns about cancelled and suspended dividends from equities, high-quality high yield bonds can replace any missing income stream without taking on excessive risk as the world navigates the economic fallout from Covid-19.

Over recent months, we have highlighted an opportunity in high yield as elevated spreads represent an historically attractive entry point, and this remains the case despite some tightening since the peak in March.

We are not bullish on the macro outlook beyond our confidence that the system will survive but in the context of an uneven recovery across countries and sectors, the balance has shifted in favour of bonds. For high yield in particular, we have seen the Federal Reserve supporting fallen angels and also starting to purchase ETFs last week. From a peak of $30 billion of investor outflows earlier in the year, the majority of this money has now come back into the US market, whereas less than half of the €8 billion European outflows has been re-invested so far.

In reality, flows are not needed in high yield as it is a naturally refreshing asset class with relatively short maturities and big coupon payments, and provides in the region of $130 billion a year in income. Excluding a few niche parts of the market, the vast majority of high yield coupons are mandatory, in stark contrast to dividends, and, for us, these bonds continue to put the income into fixed income.

This opportunity does remain stock and sector specific, however, and, as our investors will know, we largely exclude energy and CCC bonds from the Liontrust GF High Yield Bond fund, looking to avoid accumulations of thematic risk as far as possible. We have consistently emphasised the quality of our portfolio, with 80% of holdings listed on public markets and an average market cap of $24 billion, and we see no point in chasing risk given the current disruption.

At the end of April, the five-year cumulative default rate implied by spreads on the global high yield market, with a 20% recovery expectation, was 38%. Consider that the worst-ever five-year rate was 32.6% at the height of the credit crisis and the average is 16%. Consensus suggests a default rate of between 8% and 11% over the next few years but this will be very much skewed towards parts of the market we avoid, and it is exactly this spectre that is creating opportunities for active, stockpicking managers.

Highest spread, highest risk of defaults

Segmenting the market, the highest yields (with spreads of 10% or more) can largely be found in more cyclical sectors, and our fund remains significantly underweight these areas compared to the ICE BAML Global High Yield Index.

Investors might ask why a high yield fund is not looking in the highest yielding parts of the market but these are exactly the kind of thematic risks we want to avoid. With the high yielding energy sector, for example, the key factor at present is the high costs of production versus current spot hydrocarbon prices, meaning these companies are highly sensitive to geopolitics and require a rapid recovery that looks increasingly difficult.

As for real estate, analysis shows 80% of the high yielding part of this sector is highly levered Chinese property companies and, again, this is not exposure we want. The same goes for basic industry, where 60% of the sector is metals, mining and steel, as well as leisure and retail, both of which are heavily reliant on a quick recovery and a potential Covid-19 vaccine.

We expect these sectors to dominate the default picture, and therefore focus our portfolio towards idiosyncratic opportunities in less cyclical areas such as insurance, telecoms, media and capital goods.

Coming back to the question of whether high yield could replace lost dividends from equities, we have always referred to the asset class as a cousin of equities and the chart below shows that drawdowns tend to be much less. Combined with the fact that long-term returns are comparable to many major equity indices, this highlights the excellent risk-adjusted performance potentially available from high yield.

Comparing drawdowns

Examining those total returns going back the late 1990s, a couple of things are clear. First, although volatile, recoveries tend to be quick and, second, this is very much an income asset class. Defaults will erode the price return but investors have been substantially more than compensated for that by the excess income.

All the long-term positive return from high yield has come from income over time and if, as an active manager, you can avoid the companies that default, this is an asset class that can offer compelling performance, either for that long-term total return accrual or to replace the income currently missing elsewhere.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, May 21, 2020, 1:03 PM