We have recently had a stealth bull market in high yield. Credit spreads tightened and high yield performed well in the first half of 2023. Investors have been increasingly relaxed about recession risk – many have bought into the “soft landing’’ narrative – believing that central banks can perfectly land the plane.

Our view is that the market may be too complacent about the lag effects of monetary policy: interest rate hikes are a powerful tool, but they percolate through the global economy slowly, causing more and more damage as governments, businesses and consumers progressively have to refinance their debt. The huge amount of monetary tightening by the central banks over the last 12 months is only now hitting consumers and businesses and we’re likely to have a recession, potentially very soon.

Default rates will increase, and there will be greater volatility in the high yield market, which may mean more dispersion in performance among issuers and sectors. These are scenarios that disciplined active managers can take advantage of. The yields on offer in high yield are indeed high relative to history, and they offer the potential for attractive future returns; but in this environment, selectivity will be even more important to avoid the weaker names.
Muted issuance
We have been surprised at how well the high yield market has held up in an environment where banks have dialled back on risk appetite, making it harder for companies and consumers to access credit. Historically, these conditions would lead to credit spreads selling off, whereas this time high yield markets continued to be highly resilient. Part of the reason for this may be market technicals, as muted new issuance has driven investors to chase existing bonds. We do not think however that such broad-based strength can be sustained in the medium term, and investors might need to avoid situations that do not price in a weaker macroeconomic environment.

We think it makes sense for high yield investors to be more cautious today in portfolio construction, such as owning more lower-risk bonds and keeping higher cash balances to provide a risk hedge as well as dry powder that can be used to take advantage of selloffs and dispersion in the market.
Avoiding cyclicals
Nevertheless, the current market also offers opportunities to own bonds that price in the relatively weak economic environment.

From a sector standpoint, given our recessionary macro view, we think it makes sense to stay away from the more cyclical parts of the market – consumer discretionary companies, industrials or companies that are too highly levered. Healthcare and consumer staples, traditionally defensive sectors, look more attractive. In recent quarters we found also idiosyncratic opportunities in the energy sector and more recently in the financials space.

Looking through a credit rating lens, BBs look to us to be the least attractive. Bs and potentially even some tactical opportunities in the BBBs, look more interesting considering current valuations.

In developed markets, UK monetary and fiscal credibility is strained, interest rates are high, and people are worried about inflation. Ironically, this negative sentiment provides good opportunities to selectively buy high quality UK businesses at a big spread premium vs similar businesses in other regions such as the US.
Judicious selection
Emerging markets are interesting because some high yield bonds there are pricing in a pretty bleak economic environment. In Latin America, for example, some hard currency bonds, issued by relatively solid business, are offered today at valuations already consistent with a recessionary environment, providing a good risk/return opportunity.

Given the outlook for a more volatile market, we believe that judicious credit selection and risk awareness will be crucial to delivering solid returns in high yield for the near future. That means being active, intensively researching credit selection to drive risk-adjusted returns; being pragmatic, neither overly aggressive nor defensive; and being risk aware, to preserve capital and avoid idiosyncratic drawdowns.

The context is not however entirely negative for investors. Despite our caution on the global economy, history suggests that over the medium term, high yield is positioned to deliver attractive returns. To fixed income investors, yield is everything and the radical re-pricing of interest rates since 2021 has left yields very high relative to long-term average. We believe this provides a margin of safety to compensate for volatility and potentially higher default rates.

If it turns out that we are overly pessimistic and we end up having that soft landing as inflation falls and central banks dial down their hawkishness, we believe high yield will be very attractive under those conditions, too.
Global high yield market - yields are not everything, but they do matter

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