Overweighting the riskiest portion of the US high yield market in a late-cycle environment may appear counterintuitive on the surface as these credits would be among the most affected by an economic downturn. 
However, we believe an overweight allocation to weak B-rated and CCC-rated credits is warranted based on global investors’ ongoing search for yield, overvalued BB-rated issues, a constructive view of the global economic expansion, and credit spreads that imply a notably higher default rate than we expect.
With about $11.8trn in negative-yielding debt globally (down from a peak of nearly $17trn in 2019), investors’ need for yield remains palpable. The scarcity of yield is also indicated by an increasing number of non-US investors who are concerned that hedging costs may eat into potential returns from US assets and are choosing not to hedge FX exposure, as well as some European BB-rated debt that recently priced with coupons of less than 1 per cent.
The lack of value in BB-rated names is not isolated to Europe. In addition to nominally positive yields, investors also seem to prefer US BB-rated issues over lower-quality high yield amid concerns about a possible global slowdown. The composition of the lower-quality portion of the US high yield market may also play a significant role in this preference as half of these issuers are in economically sensitive, cyclical industries. After generally moving in synch in recent years, mid-2019 marked a clear directional divergence between the highest and lowest-quality portions of the market, resulting in a spread differential of nearly 800 basis points as of mid-January 2020.
Yet, amid progress on trade agreements between the US and China, signs that the global manufacturing sector may have reached a bottom, and continued accommodation from major central banks, we see a backdrop that appears ideally suited to prolonging the global economic expansion. As such, we also maintain a low probability, say 10 per cent, of the US entering a recession in 2020.
Therefore, with the divergence in the lower-quality portion of the market resulting in a relatively attractive spread pickup, we set overweights of up to 10 percentage points on the weak B and CCC-rated portions of the market as the year began.
Given our expectations for the global credit cycle to continue, lower-quality credit spreads continue to imply a default rate that is significantly higher than we expect in 2020. For example, the CCC-rated option-adjusted spread (OAS) of 983 basis points as of mid-January, implied a default rate of nearly 11.4 per cent, well above the historical annual rate of about 7 per cent on the CCC-rated segment of the market. In addition, we see the broad-market default rate remaining below the long-term historical average of about 3.5 per cent and possibly below 3.0 per cent should the energy and commodity sectors, which comprised about half of the default activity in 2019, stabilise further.
Our preferred positions in the B and CCC-rated segment of the market consist of overweight’s to independent power producers and US consumer-related names. We recently shifted to an overweight in the energy sector, which appeared especially oversold, with a particular focus on producers and distributors of natural gas and related fuels.
We’re also opportunistically and selectively adding healthcare issuers. We’re offsetting the overweight to higher-beta issues with CDX and positions in AAA-rated CLO (collateralised loan obligation) tranches. In considering environmental, social, and governance factors as part of our investment process, we’re cognizant of the effect that ESG (environmental, social & governance) concerns may have on lower-rated energy and commodity names. Although these OAS may tighten and contribute to attractive risk-adjusted returns, we acknowledge that these issues could ultimately continue to trade at a discount to similarly rated names with fewer ESG concerns.
There are caveats to moving down in credit quality. A primary concern is that we may be misjudging the general strength of the global economy, and if a downturn approaches, many weaker B and CCC-rated names could be severely affected. Furthermore, while credit selection is a key component of generating alpha across varying investment backdrops, the move down in quality emphasises the importance of picking credits that may withstand weaker economic conditions.
In addition, identifying an attractive lower-rated credit is one thing, but finding fairly-valued bonds from the same issuer is another. These issues can be difficult to source, particularly in the belly of some steep credit curves, yet we have added exposure during some periods of lower liquidity. Volume in the high-yield primary market has also accelerated recently and should provide opportunities to adjust exposure as needed.
In conclusion, when evaluating allocations in the current late-cycle environment, the US high yield market remains vastly bifurcated with overvalued BB-rated issues and some deeply discounted weak B and CCC-rated names. Granted, there are risks to overweighting the lower-quality portion of the market, but given our base case for a prolonged credit cycle, the larger risk to performance could be maintaining overweights to the BB-rated segment of the market, particularly as lower-quality credit spreads imply a far higher default rate than we expect in 2020.
Robert Cignarella is head of US high yield at PGIM Fixed Income. The views expressed above are his own and should not be taken as investment advice.