“When we analyse high yield credits, one of the first questions we ask ourselves is: are management interests aligned with bondholders, or shareholders?” Al Cattermole outlines how to find investment potential in an uncertain environment.
Government chaos would send it sliding down the ratings spectrum, but fortunately, prospects across the real credit landscape are more interesting.
- Good credit investments require consistency of management and an alignment of interests between management and investor interests – given the UK’s rotating task of prime ministers and chancellors, it would be trading significantly wide to ratings peers if it were a high yield (HY) corporate bond.
- In the real HY corporates universe, sentiment is bearish but valuations may have already moved sufficiently to compensate for the slowdown to come.
- Excluding a financial crisis-style event, high yield bonds offer robust positive return potential, with the range of returns skewed to the upside.
- Default risk could increase, but we’re not seeing the sector concentrations that caused default spikes in the past.
- Acknowledging downside risks, we are taking an “up in quality” investment approach.
- We prefer the US to Europe, and BB credits over the more economically sensitive CCC ratings band.
If the UK were a corporate bond, with the government representing the management team, it would be trading significantly wide to ratings peers due to considerable concern regarding governance and strategic direction.
When we analyse high yield credits, one of the first questions we ask ourselves is: are management interests aligned with bondholders, or shareholders? Indeed, when looking at any credit, you want to see consistency of management and for your interests to be aligned.
Given the current UK government is so new, with a rotating cast of prime ministers and chancellors (at the time of writing, we’re at a count of two and four respectively so far this year), we can’t take a 30-year, five year, or even one year view on how it’s going to act and what impact it’s decisions will have on the credit quality of the country.
The government have also tried to focus on short-term priorities − helping people through the winter and getting ready for the next election − but the market has pushed back to try and force some responsible long-term planning to take place.
Turning to the real high yield credit landscape, sentiment on the economic outlook is very bearish, but valuations may have already moved sufficiently to compensate for the slowdown to come. Investors are concerned that spreads haven’t moved to price in a full recessionary scenario, but a key thing to remember about high yield it’s that it’s a ‘yield’ asset class – it’s made up of rate and spread.
Today, we have a yield of 9.81% on the ICE BAML Global High Yield Index (USD Hedged as at 19 October). Aside from during the global financial crisis, the index has only spent a handful of days in 10%+ territory.
So, do we think the market is going to sell off and stay above 10% for a significant period? I’d say no, this seems unlikely. If we do move into a recessionary environment, spreads will rise, but these will be offset by falling government rates, and you’ll be collecting a healthy coupon.
While we’re facing a lot of uncertainty and it’s impossible to predict what the remainder of 2022 will deliver, excluding a financial crisis-style event, high yield bonds offer strong positive return potential, with the range of returns skewed to the upside.