Since the global financial crisis, investors have been getting to grips with negative interest rates and negative yields, but the recent shift into negative territory of European high yield bonds is a new curveball. 
This seeming oxymoron is the result of several interrelated factors currently at play in global credit markets. First, the recent dovish pivot by major central banks has resulted in a record amount of government bonds offering investors negative yields. For example, the Swiss government bond curve is offering negative yields including the 30-year point. Additionally, German 10-year is at all-time lows and the US 10-year is close to 20-year lows. High yield is a spread product and is priced as a pick-up versus government bonds, resulting in a knock-on impact on all yields by the level at which government bonds are trading.
Second, the negative yield phenomenon is solely present in the ‘BB’ rating category, which is currently in the sweet spot for many asset allocators. Unlike the low end of high yield, which requires economic growth to deleverage ahead of the next refinancing cycle, higher-quality credits can withstand macroeconomic volatility through dividend and buyback cuts.
Third, there is increasing scarcity of value in high yield as the universe has been shrinking over the past 18 months. With rising stars outnumbering fallen angels, we are seeing an increasing number of low investment-grade companies choosing to cut dividends and buybacks to de-leverage. Prior to the recent dovish shift, many lower quality transactions, such as leveraged buy-outs, were going to the leveraged loan market. As higher-quality issuers choose to repay rather than refinance debt to prepare for the upcoming economic weakness, there is lower need for new issuance.
How does the negative shift impact investment approaches?
As capital appreciation becomes a bigger portion of the overall return, the demand for high active share strategies will increase because alpha becomes more valuable. In other words, if the outperformance target remains the same while the level of carry you can get in the market is lower, it becomes a bigger percentage of your total return. As our previous research has indicated[source], high active share strategies are better suited to deliver alpha, be it positive or negative. A passive approach will no longer be an option for many asset owners.
Unconstrained investing is becoming increasingly attractive versus narrow mandates, as crowded positioning in some parts of the market will require the ability to invest across the capital structure globally to perform. Flexible credit strategies that are able to move capital between regions, ratings, sectors, points on the credit curve and various parts of the capital structure will be in a better position to deliver attractive risk-adjusted returns for investors. The majority of the negative-yielding high yield bonds are concentrated at the front end of the curve, which means that picking the right company is only part of the story in credit.
The shift to negative yields is also putting the spotlight on ESG [environmental, social & governance] integration, which remains at the forefront of innovation in fixed income investing for several reasons. Firstly, innovative ways of generating alpha such as engagement on ESG issues will gain popularity among asset allocators. Secondly, ESG is one of the important tools in the downside protection toolbox given its risk-management capability. As we go back to a lower interest rate environment, investors need to consider tools for downside protection outside of the traditional and widely-used barbell approach, which uses a combination of risky assets such as high yield and safe-haven assets such as government bonds. This is especially true given the risk of a change in the negative correlation between risky and risk-free assets that this approach relies on. Defensive trades that can exploit relative value across different parts of the capital structure or parts of the curve will pay an essential role in the new era.
Credit remains attractive and there are plenty of opportunities within global credit for investors with a flexible approach to capital allocation. The demand for fixed income is a structural phenomenon driven by an ageing population. If Europe were to continue down the road of Japanification, which is characterised by low growth, low inflation and high savings, this shift in demand for spread products is unlikely to change any time soon.
Andrey Kuznetsov is a senior portfolio manager at Hermes Investment Management. The views expressed above are his own and should not be taken as investment advice.