Credit spreads have rallied meaningfully since the third quarter of last year – indeed some segments of the market have since traded very close to their historical tights. To put these moves into perspective, at the end of April 2024 the ICE BofA Global High Yield Constrained Index was trading at a 90th percentile spread. Put another way, high yield spreads had only been tighter 10% of the time going back to the index’s inception in 1997.
Does the current tightness of spreads present a risk for high yield investors? Not necessarily. Historical data shows that the high yield market often trades tighter-than-average for extended periods of time, and on some occasions have done so for years. Most notably this happened in 2003, when spreads remained below median for over 4 years.
ICE BofA Global High Yield Constrained Index – spread history
It’s also notable that, when spreads move wider in risk-off periods such as 08/09 or the Covid pandemic, they tend to do so in dramatic fashion – spiking sharply but for a relatively short period of time. In short, high yield spreads do not tend to be evenly distributed around long-term averages.
Importantly, in a tight spread environment the upside potential from any further tightening in spreads is generally limited. For investors this is a challenge as, while there will always be idiosyncratic credit stories that offer good opportunities, these are rare gems that can be hard to find when the overall market trades tight. So credit investors need to get more creative about the ways they can seek to generate alpha.
The active edge in credit investing
As active investors ourselves, we deploy specific techniques in environments such as this. An example of one such technique is a focus on shorter duration refinancing trades within high yield, where it is possible to generate market-beating levels of return at relatively low volatility.
Unlike investment grade bonds, which have bullet maturities, high yield bonds are callable. This creates uncertainty around the likely refinancing date, and means it is harder for markets to efficiently price these bonds. When we invest in short dated high yield, we look to identify bonds where we believe the market has not correctly priced in the likely repayment date and where there may be significant upside from an earlier call. These bonds also typically exhibit lower levels of volatility than longer dated bonds in the market; and so on a risk adjusted basis, this style of investing can generate very attractive levels of return.
The short-lived nature of these opportunities is advantageous from a credit research perspective, because our analysts can forecast a company’s performance with more confidence over the short term than the long term. This is a double-edged sword, however, as capital needs to be frequently recycled into new ideas as the bonds are refinanced. The work needed to do this is both highly skilled and very labour intensive, and so investors wishing to adopt this approach will generally need to be supported by large teams of experienced analysts, as we have at Jupiter.
Emerging refinancing trends
Something quite unusual about the current market is that there is a large stock of “legacy bonds”, which were generally issued in the environment of lower interest rates that we saw prior to 2022 and, as such, have low coupons. Because base rates are higher now, these low coupon bonds often trade at substantial discounts to par value.
Understandably, CFOs of the issuing companies have hardly rushed to refinance this debt given how relatively attractive – from the company’s perspective – the coupons are in the context of current markets. The upshot of this is that the proportion of relatively short-dated bonds in the market has increased.
Global High Yield: % of the index maturing in less than 3 years
On the subject of refinancing, one interesting trend we have observed recently is for issuers to tender for bonds, rather than calling them. The tender will be below the call price, but generally investors of the tendered bonds are offered preferential allocations on the newly refinanced issue. This can be advantageous for investors when the new issue pricing is attractive; however we would caution that a discerning approach is warranted here. The risk profile of the newer, and obviously longer-dated, bonds will be very different to those that have been refinanced. In a longer-dated instrument, bondholders are required to take a longer view over factors such as the performance of the company; the spread environment and the evolution of the macro environment. In the current tight spread environment, we are cautious about those risks as often we find prices do not offer sufficient compensation for them. We therefore take a disciplined approach, often preferring to stay in the shorter-dated refinancing trades instead rather than switch into longer dated new issues.
An interesting opportunity for active investors
In our view, the combination of tight spreads, relatively low cash prices, and relatively short duration bonds creates an interesting opportunity for active investors. Those able to correctly identify bonds that trade below par with a high probability of being refinanced quickly, can generate very attractive levels of yield as the difference between the purchase price (below par) and the par repayment is crystallised over a short time frame. Even in today’s tight spread environment, we are still able to find very attractive investment opportunities using this technique, whilst at the same time minimising beta. This investment style relies on thorough credit research, but we believe the depth of expertise we have at Jupiter equips us well to do exactly that.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
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