There is an interesting debate going on in the world of fixed income currently. Is high yield credit a cyclical asset class or a structural growth story?
To us, the asset class is cyclical. A good example of this can be seen in the average price of the Credit Suisse High Yield Index going back almost 30 years. See below.
High yield is cyclical
Over time, the average price of the high yield index has traded between 67 and 105, 68 and 102, 59 and 104. We are now at an average price of 105. How is this not a cyclical asset class?
You should love high yield with average prices in the 60s, while there should be some degree of caution at the valuation levels we see today. As a strategic bond manager, we use high yield at certain points in the cycle to boost returns for investors. Over the life of our Henderson Strategic Bond Fund we have had allocations ranging from 20% to 80% in pure high yield. We are currently at 55%, and we believe this is the peak for this cycle.
High yield is cyclical and within the asset class there are many cyclical industries. Generally speaking, we do not lend money to the autos, shipping or airline industries. Our motto has basically been: ‘if it rolls, floats or flies — we rarely lend it money’.
We do not like the heavy cyclical industries — we prefer the stable, dull, but still quite levered opportunities. These include companies in cable TV, mobile telecoms, healthcare and packaging.
We also avoid industries in structural decline, such as yellow pages phone directories or regional newspapers. I would argue retailers like Matalan are also in structural decline, these are companies set to see business eroded by online. I am not sure a company such as Matalan should exist. Whether a company should exist is a huge part of what we discuss in our team. We all recognise a company like the AA should exist, but I am not so sure about Matalan.
Essentially, we believe high yield credit is a cyclical asset class, which should be used strategically. However, wearing our income hat, there is always a need for a healthy allocation to higher yielding assets to deliver the income required for investors. While it may be difficult to avoid a short-term erosion of capital in risk-off environments, careful security selection can insulate investors from periods of higher defaults. This is the approach we take for our Henderson Fixed Interest Monthly Income and Henderson Preference & Bond Funds. Having said this, we have allocated very little to high yield markets this year as we have become slightly cautious of current valuation levels.
For more insights on fixed income markets, visit us on twitter: @StrategicBond