Like almost every sector, high yield bonds suffered badly in 2022, as persistently high inflation and the resultant tightening of monetary policies by central banks presented formidable headwinds
As a result, funds in the global sector lost in excess of 10% in the past calendar year. But there are now plenty of positives to consider, not least that there is growing expectation from many of the fund managers and economists we speak to that inflation will fall back markedly in 2023.
That is good news for the bond market – with yields on the rise as a result. I recently saw a chart from Bloomberg which showed both Treasuries and investment grade bond yields had risen by around 3% during 2022 – income is back on the table after more than a decade of dearth. Yet, despite yields rising almost 5 percentage points in 2022 alone, global high yield bonds still appear to some as too risky in this current environment.
There is some merit for that concern as we appear to be heading towards the most telegraphed recession in history. The US bond yield curve is inverted, which is counter intuitive, and has signalled every recession since 1960. But it’s not all negative news – we have almost full employment in the developed world and oil prices have eased.
There is also an argument that a recession induced by central bank tightening is often less severe. By contrast, Janus Henderson global head of high yield Tom Ross says that during the 2007-09 global financial crisis, spreads widened to almost 2,000 basis points in the high yield market – reflecting fears the banking system may collapse.
He says: “Today, banks are well capitalised. More recent crises, such as the 2011 eurozone debt crisis, the 2015 oil price collapse, and the 2020 Covid pandemic have caused spreads to peak well below 1,000 basis points.”
What we are seeing is a change in the cycle. While macroeconomic uncertainty is likely to persist, central banks’ attempts to cull inflation will result in greater margin pressures and increased funding costs. In a nutshell corporate balance sheets will come under pressure and defaults may rise to some degree.
But yields are likely to continue rising – moreover, history shows us that global high yield bonds have outperformed the previous two times the Fed hiked rates (2004-2006 and 2015-2018). Both times historical annualised returns from global high yield bonds were in excess of 7% – well above other parts of the fixed income universe.
Plenty of positives from here – but never has the active approach been more important
Clearly global high yield spreads are likely to remain volatile – they were over 500 basis points at the end of November 2022 but have fallen back slightly since then. However, Tom Ross says markets typically overshoot on fear – weakness in corporate earnings and negative employment prints are likely to catalyse a spike in peak spreads, most probably in the first half of 2023.
The big worry is the threat of defaults – but I’d argue a lot of this is already in the price. Rating agency Moody’s predicts the global high-yield default rate will rise from 2.6% in November 2022 to 4.9% in November 2023. An investment note from the M&G fixed income team says the current spread levels translate to an implied five-year default rate of around 30% – which is much higher than they expect and would be “as extreme as the worst-ever default experience”.
Artemis Global High Yield bond co-manager Jack Holmes believes there are a number of reasons why this default cycle will not be as bad as previous cycles. He points to the improving structure of the global high yield market as a major factor in this.
He says: “The share of BBs in the market – the highest quality part of the high yield market – was 40% going into 2008. CCC’s – the riskiest part of the market – made up 17%. Today BB’s account for 58% and CCC’s make-up 9%.”
I want to put this into context – and show not all high yield carries the same risk. Research from S&P found that between 1981-2021 the average chance each year of a default for CCC bonds was around 25%, while for BB it was just 0.6%. The changing landscape means that across the sector, the average chance of default has fallen from 7.5% in 2008 to less than 4% today.
Aviva’s global co-head of high yield Sunita Kara says new issuance is expected to pick up in 2023 if conditions allow, with BB-rated issuers likely to retain better access to funding than their lower-rated counterparts.
She says: “Many companies are in a stronger position than during previous downturns. Robust earnings among BB issuers – some of them ‘fallen angels’ that entered the high-yield universe in the wake of the pandemic – helped bring average leverage ratios down in 2022, while interest coverage also improved.”
Although they are likely to deteriorate, starting fundamentals are strong. US high yield gross leverage (debt as a proportion of earnings) is at 3.6 times earnings, around the lows of the past decade, while interest cover is at a 20-year high, with earnings able to cover interest expense by 5.8 times.
While there are clearly safer options for income in this new cycle – there is a strong case to reconsider global high yield given the maturing characteristics it is demonstrating. Defaults will be an issue on a sector-by-sector basis, but the right active manager will be able to tap into companies with strong fundamentals, whilst delivering high single digit yields in this unique environment.
Funds to consider include Man GLG High Yield Opportunities and the Artemis Global High Yield Bond, both of which have managers with excellent long-term records as pure stock pickers.
Those who may prefer a more balanced exposure might consider the M&G Optimal Income fund and the Aegon Strategic Bond, both of which have a reasonable allocation to high yield.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above should not be taken as investment advice.