Staying Patient in Global High Yield Credit
Fund manager Adam Darling says high yield credit has had a good run so far this year, but that investors should continue to watch the economic data closely for any threats to the prevailing soft landing narrative.
It’s been a good year so far for high yield credit, and this probably reflects the market’s relatively optimistic view that we are headed for a soft landing. Last year also was positive for the asset class as it rebounded from very depressed sentiment and valuations in 2022.
The rate cutting cycle has begun in the US, Europe and UK, and there is market confidence that central banks have acted sufficiently quickly to avert a recession.
It’s interesting that market sentiment is so positive even as some regions are quite soft. Europe’s economy is weak, for example, with Germany in an industrial recession. Weakness in China’s economy has finally forced the government to introduce aggressive stimulus measures.
Investors are very focused on US economic data, with most believing that the US will be able to power the global economy to avoid a significant slowdown.
In my view, the key theme of the next few months is patience. We need to watch the data and observe the lagged effects of monetary policy. Soft landing or not? I don’t yet have a strong conviction either way, but recession would be a shock to market confidence given bullish outlooks already priced into credit spreads. There is a lot going on: the start of a rate cutting cycle, a US presidential election campaign, signs of a slowing US job market and ongoing geopolitical risk in the Middle East and elsewhere.
Watching and waiting
The yields on offer in the asset class at the moment are high relative to history, with the global benchmark yielding 6.8%¹. This means high yield credit investors can collect the coupon while watching and waiting.
One of the technical risks in the high yield market that has greatly reduced this year is the so-called refinancing wall. This refers to the high number of companies which had to refinance maturing bonds at higher rates. This has happened without disruption over the last few months, which is a bullish signal for the asset class.
Our global high yield strategy, which observed its five-year anniversary in August, follows an investment philosophy that includes three core principles, which are to be active, pragmatic and risk aware. By active, we believe intensively researched credit selection to be a key driver of risk-adjusted returns. By pragmatic, we mean that positioning must reflect our evolving views – we are not inherently aggressive or defensive, and neither long duration nor short duration. By risk aware, we aim to preserve capital and avoid idiosyncratic drawdown risk.
Tight spreads
With our investment philosophy in mind, we can see that a soft landing is fully priced into credit spreads, which rallied significantly in Q4 2023 and haven’t widened significantly since. When valuations are full and markets are confident, we think it’s sensible to think hard about prospective risk / return and to be slightly cautious.
With many bonds looking expensive, the challenge is to find ideas that offer a better risk/return than that of the overall market. We are consistently finding those ideas, while looking to avoid expensive parts of the market. We also think it makes sense to have good levels of fund liquidity, including cash, to take advantage of potential market volatility.
We currently have lower exposure to cyclical credits such as industrial and consumer discretionary sectors. We prefer consumer staples and healthcare. Cyclical valuations are expensive, particularly if economic data challenges the soft landing narrative.
Careful credit selection
We currently see more opportunity in Europe than the US, where credit and other kinds of risk assets look pricey. While the European economy is not as robust as the US, we see more opportunities to generate above-market returns in Europe. We see emerging market credits as tactical; we buy selectively when we see good value relative to developed markets.
Careful credit selection is the key. It’s what we do as active fund managers. The yields on offer are attractive from a historical context. I believe that in high yield you don’t need to be too greedy. You should chase risk when conditions are in your favour. When valuations are not so compelling, it makes sense to step back and wait.
Global high yield market: spreads remain tight from a historical perspective
Source: Bloomberg, Global HY Index: ICE BoFA Global High Yield Constrained Index, as at 31.08.24
¹ICE BofA Global High Yield Constrained Index, yield to worst, as at 30.9.2024, via Bloomberg.
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