Portfolio Managers Seth Meyer and Tom Ross join Adam Hetts, Global Head of Portfolio Construction and Strategy, to discuss the prospects for the global economy and why relatively robust fundamentals among high yield borrowers offer grounds for optimism given that markets have already priced in a lot of the inflation concerns.
- High-yield bond prices have sold off as rising interest rates have weighed on returns and non-traditional investors (so-called tourists) exited the asset class, but their relatively high yields have typically helped them outperform investment-grade corporate bonds and government bonds in the first few months of 2022.
- COVID tested high yield issuers but it also prompted useful refinancing and higher cash reserves, meaning many issuers would go into any economic slowdown from a position of strength. Sectors of the economy are still dislocated, however, so it is necessary to look at corporate issuers on a case-by-case basis.
- The rapid rise in government bond yields, particularly among U.S. Treasuries, has pushed up the yield on high yield, providing an opportunity for investors to more convincingly achieve the name of the asset class – high yield.
Adam Hetts: Welcome to Global Perspectives and following on from our last episode where we looked at stagflation risks with our REITs Team. Today we'll look at stagflation and some other key macro topics through the eyes of our high yield investors. And to help with that, I'm happy we're doing another episode with Seth Meyer and Tom Ross. Seth is based here in Denver with me and Tom is in London and they're both portfolio managers covering high yield and investment grade across quite a few of our Janus Henderson strategies. So all right guys, thanks for braving another episode with me.
Tom Ross: Thanks, Adam.
Seth Meyer Thanks for having us.
Adam: I think the best place to start is we've got slowing growth, inflation and rising rates. You’d think all that would spell disaster for high yield markets but amazingly, high yield’s looking better year-to-date than almost any other fixed income benchmark. So, maybe Tom, could you start with just catch us up on how high yield performance is stacking up and why it's outperforming so many other fixed income benchmarks this year?
Tom: Yes, so for high yield, the total returns have been poor overall. But as you say, when you compare it to other asset classes, it's not too bad. Look partly, it's a lower duration asset class anyway, typically, sort of three to four years. Obviously, the big underperforming part of fixed income has really been the duration element so that lower duration has definitely helped. Maybe not to the same extent as loan markets and floating rate markets but again, it has really sort of dampened that downside volatility. And in fact, it still has mostly been duration that's caused most of that underperformance. Depending on what index you're looking at, sort of 5½% negative total returns for let's say, global high yield in the first quarter [of 2022], only about 1.4% of that was actually from the spread return. The rest of it was from duration. So I guess, why is that in an environment where we are talking about “Is there going to be a recession next year?” This is normally the time when everyone would just be panicking out of high yield. I think the difference is the only real investors that were I guess overextended into the high yield market were investment grade Agg* funds, sort of total return funds, that saw high yield as an opportunity over the last handful of years. They would pile into the BB part of the market and most of that unwound as they got concerned about central banks changing their tune in Q1 of this year. But in fact, most high yield investors haven't been overly invested. Most institutional investors, because overall yields have been fairly low, haven't really been invested so there haven't been that many people selling I guess what we call the traditional high yield of you know, Bs and CCCs. And that's meant that the market hasn't really underperformed to the extent we might have expected.
Seth: Yes, and if I can add just a couple of points, I think high yield is an asset class that historically has performed well in Fed hiking cycles and in inflationary periods. And I'm not that surprised to see high yield outperforming again. The key risk in high yield as Tom was alluding to really is spread risk. And at the onset of 2022, I don't think many people actually had recessions forecasted in their crystal ball. It still looked like things were going to be just fine in terms of growth. As we've progressed, we've had other situations, geopolitical situations arise that weren't on people's radar four months ago and that's created more of an issue of inflationary pressures that are getting even more out of hand and perhaps even a significantly more aggressive Fed [U.S. Federal Reserve] than many were thinking just three or four months ago. So I think pulling forward your recession expectations seems reasonable here. But let's remember, the Fed has moved once so far and the markets have really corrected to a more aggressive Fed stance. Just looking at the curve itself, right, you look at the two-year [US government bond yield] moving from 30 basis points to 250 basis points in a very, very short period of time. That's already tightened financial conditions. So the question going forward for high yield really is how we're going to balance the outlook of economic environment recession probabilities, and how that plays into spreads.
Adam: And you just said during inflation, high yield can outperform. So if you've got rising rates and inflation and high yield is a fixed rate asset class, how does that play out? Does inflation not affect high yield as much or how does the investment playbook change in an inflationary environment for high yield?
Meyer: I mean generally speaking yes, you have fixed rate debt that you're holding. The thing to remember is, you already are being offered a significant spread advantage over the given Treasury that you're being compared against. And that spread advantage usually compresses as the Fed is raising rates or there's inflationary pressures on the curve. Predominantly because when those things are usually happening, economic growth is usually just fine. So it's usually more of a function of the fact that economies are doing okay in periods where rising rates and inflation are both problems and that actually is what lends itself to perform well. Fundamentally, if you look deeper into the individual companies you know, you're talking about growing cash flows, the ability to de-lever because economies are doing fine and that's usually the buffer that high yield offers.
Adam: All right, you made the point that some core funds in high yield were essentially tourists that sold pretty quickly during the volatility year to date. So with you guys as natives or locals or lifers in the high yield space, with those tourists running out, what kind of dislocations or opportunities are you seeing that are unique because of that event?
Seth: Yes, I mean we can talk specifically about what we're seeing in the BB space, which has predominantly been the area that the tourist as you're describing left. The BB part of the market is really the highest quality part of the high yield market. BBs started the year under pretty significant pressure and underperformed their CCC counterparts as the non-natural buyers were exiting the high yield space and those asset classes are generally more influenced by the direction of rates than a CCC bond may be. So when you think about what's happened in the BB space, the interesting part has been how low the absolute dollar prices are becoming. Longer duration BB credit has an average dollar price in the 90s right now, the low 90s, which is really attractive when you think about a seven or eight year piece of paper and you know, a point or two from your total return will be just that bond accreting back to par. So we're getting some unique opportunities I think today to take advantage of higher quality companies at what we view to be pretty cheap valuations. And I think that that's been sort of the most direct outcome of the tourists leaving the high yield space. I'm sure Tom has other angles on it as well, but that's the most obvious part for me.
Tom: Yes, I guess as well, the investment from those non-native high yield investors has typically been through things like Exchange Traded Funds (ETFs). And obviously, that is quite indiscriminate in how that is invested within our market. So as soon as you have, I guess, anything that isn't considering things solely from the bottom up, which is how we tend to do things, that's just going to provide those opportunities because most selling is based upon which names are largest within an ETF as opposed to based on whether it has a better credit outlook versus any other company. So it certainly provides us with this great opportunity to try and pick those companies that we believe from a fundamental perspective or an ESG perspective or whatever it might be that looks more attractive, as opposed to just what's dictated to by benchmarks and ETFs.
Adam: So it seems some good reasons for optimism. And some opportunities there with some of those dislocations that some of those flows have created. And Seth, you mentioned earlier that the rise in rates, it could be good. Inflation could be good if it's a sign of a healthy economy, but there's of course, a lot more talk about recession risk in the US this year or next year. So I’m curious, are you guys also concerned about a recession or not and why? And then in a recession kind of environment, how does the high yield investment decision process change? Like what types of sectors and how does security selection change in a recession environment?
Tom: It depends very much what the recession is going to look like. Obviously, if we simply have a very short and shallow possibly even a technical recession in terms of, you know, the figures make it a recession but the growth is not all that bad, then that's probably not going to be something that we’re going to be too worried about. It will probably associate itself with wider than usual spreads. But obviously a lot of that is potentially already priced in, certainly when we start thinking a year out. But if we do have a really deep and long recession, which is not our base case, but I think we have to acknowledge is a risk scenario that does have a probability attached to it, then obviously that's when you will see more stress within high yield. It will lead to lower prices especially of those lower rated CCCs and more cyclical credits and that will ultimately lead through to a higher default rate as well. So it depends very much what it looks like. I guess one of the things is you mentioned about sectors there. And sectors are so interesting at the moment because typically at the moment, this sort of later cycle behavior, you'd be getting severely underweight through durable goods and things like that. And look, we have reduced risk in areas like autos. But it's interesting when you've got auto manufacturing that is at production levels that are similar to what we had for many companies back in the global financial crisis. How much lower can it go in terms of volumes? Yes, their ability to get the margins on those vehicles is going to be lower but it's not like we've had some amazing time where production volumes have been through the roof. There's you know, cars everywhere, everyone's got a new car already. No one's been able to buy a car for ages. Now, does that make us positive on the auto sector? Well no, not necessarily, but it also doesn't mean we want to get super "beared up," either. So it's almost not as simple as just saying it’s cyclicals or not, durable goods or not. It’s really thinking about each specific market and trying to decipher exactly how that sector is going to play out in the various scenarios that we might have coming up in the next 12 to 18 months.
Adam: So we're talking about some of the optimism in the face of inflation and then some optimism around those unique opportunities in the BB space given some of the outflows and selling that you saw year-to-date. But this is a bond conversation, so got to stay a little bit more negative. So past recession risk, any other red flags you've seen in the high yield markets that are worrying you guys, just thinking about the rest of the year?
Seth: So from the perspective of just corporate health, I think one of the reasons that our base case isn't for a severe type drawdown or recession has just been the strength of balance sheets within corporations worldwide. You know, remembering back to how dark the days were in March 2020, many corporations around the world who had access to capital, utilized that ability to access capital and built war chests of cash. Frankly, just because of the concern of how long, how difficult all of the things that we were all talking about that was going on during that period. Subsequent to that debt funding in March and over the next, call it 18 or 24 months, the corporations’ not only cashflows, but their ability to de-lever over the past 18 months has been quite tremendous. In many cases in the investment grade category or the high yield category, you're talking about leverage ratios, so cash flow to the total debt that they have on their balance sheet, lower than they were going into COVID. And the interest coverage ratio is significantly higher because they were able to issue at such low coupons. So corporate credit risk right now when you look at default rates or distressed ratios or traditional credit metrics, they look phenomenal. And it's one of the key reasons that we think corporate credit spreads are holding in so well despite the fact that we've gotten this view that recession might be being pulled forward. So if you think about that from the corporate perspective and then you compare it versus the consumer side, particularly in the United States and it's more acute here because of the stimulus packages that were directly targeted on the consumer side. But consumer balance sheets, so if you look at net worth compared to total debt, unemployment ratios, look at wage growth, all of these other things you're thinking they look really, really positive. So you know, it's hard to paint a picture where we see a significant drawdown because there's just not an area that we see where there are completely offside excesses. I don't know, maybe U.S. housing is an area of the market that needs to slow and pricing is a little out of control. Autos, those will be self-correcting as we bring more supply online. But you know, what the Fed is doing is trying to cool the areas of the market that actually are or seem to be a little overheated right now, like housing. And higher rates will certainly do that with mortgage rates now piercing through 5% for a 30-year fixed rate. That's going to slow the market. There's no doubt about that. There aren't enough cash buyers in America to offset that slowdown. So it's hard for me to get completely bearish even though we've had a really tough start to the year across the entire fixed income landscape as the world has now repriced. A world of easy money with one a little bit tighter and I think this is all normal processes. It's happened significantly quicker than most processes before. If you think about the Fed rate hiking cycles of the early 2000s of a quarter point every meeting, we're on an accelerated pace of tightening. But you know, that has to be compared to the strength of the underlying economies. And the reason they feel the need to do it isn't just because of the inflation problem, it's because the economies they think can handle it. So I don't have one item that is really scaring me or the situation where things dramatically change other than you know, the geopolitical things that are happening that are very, very hard to forecast. Right now, the underlying health of corporates and consumers looks very, very good to us as we look forward.
Adam: Tom, anything you're losing sleep over?
Tom: No, the only point I probably would mention, is we did see a pickup in merger and acquisitions (M&A). It never really got the ability to get too ahead of itself in terms of the excesses that we might have seen prior to the Global Financial Crisis, etc. But I guess we've been more selective in some of the new issues in some of the M&A deals that have been coming through. We have bought a lower proportion of those new financing deals than we might have done in the past just because there was a little bit of that late cycle M&A behavior coming through. So again, it was something we were aware of but again, I don't want to overstate it as an enormous risk because the weakness we've now seen has sort of nipped it in the bud before it became a potentially bigger issue, which I think it might have done had we had another 6 to 12 months of that type of bull market.
Adam: So base case, nothing too worrisome in the immediate horizon. But if you did kind of push things into some kind of sell-off or even crisis scenario. Going back to 2020, we had in both the U.S. and Europe central bank backstops for credit both of which, correct me if I'm wrong, I think were totally unprecedented. Whether or not they actually activated that spending and buying in the credit markets, it does create this moral hazard of sorts I’d assume. I mean as high yield, as credit investors and you start thinking outside your base case that there is that kind of sell-off. Is moral hazard a question for investors in the markets? What do those backstops mean when you do start thinking about these tail risk scenarios?
Seth: So one thing to remember, right, is that the Fed is not going to be stationary or static and they are very focused on rolling inflation in the United States, no doubt about that. They're not going to stop until they start seeing core Consumer Price Index (CPI) or their preferred measure of Personal Consumption Expenditures (PCE) start to decline to levels that they're comfortable with. I do not believe the idea that inflation could power through a significant slowdown caused by a recession, it seems illogical to me. And many of the issues we're dealing with, with supply chains or just using autos as an example, if you eliminate the demand, the supply quickly catches up. You have no problem as far as pricing at that point and we start to see kind of the air being let out of the balloon if you will, from an inflation perspective. So I think when you think about the Fed and their willingness to participate in markets outside of their sort of long-term norm, 2020 was a unique situation. They were getting really involved in credit markets that I don't view as a normal path forward for the Fed unless they believe that corporations will not have access to capital. Fundamentally, what they were doing in March was just to make sure (March of 2020), just to make sure that companies had access to capital in the event that this was going to be a very long drawn-out situation where we had to have corporations shut down for very long periods of time. So it made logical sense for them to provide some support to markets where financing was the key. And really, when you think about what companies needed in March and April of 2020, it was nothing but cash. And it was to continue to pay bills, it was to continue to pay rent, it was to continue all of the things that we all know. And now we look back on it and say, “Well the period was relatively short. Did they need to be as supportive?” I don't know but hindsight is 20/20. As you look forward, the moral hazard is there that perhaps they would get more involved into markets that aren't natural to them. And their willingness to do it before kind of gives investors the comfort that they'll do it again. We would be, I would think in order to see a situation where the Fed is back in supporting markets, we would need to see a significant move in markets for them to change their current path. So yes, it's always something that you're thinking about, particularly if there's a significant drawdown at some point. But you know, we have to remember how unique March of 2020 was and what they were actually trying to accomplish and that was to keep liquidity flowing. So you know, is that our path going forward? It seems unlikely, but they've shown their hand once so they would probably if they had to, do it again.
Adam: Okay, that makes sense. Go ahead, Tom.
Tom: I was going to say from the European Central Bank (ECB) perspective because if we think about where most of those corporate purchases have happened, it's been European investment grade. That's been the big area, the exuberance of central bank almost overreach in terms of their participation within the market. And obviously they have an enormous, over €300 billion worth of corporate bonds on their balance sheet. Obviously, that would be the risk that if that starts to unwind. Currently, they're still purchasing and they will still reinvest those purchases for some time. But I guess the big risk is if anything like that unwound, I still remember back in 2015 where you had a period where European investment grade was the weakest part of all credit markets. You had sellers from funds, you had a huge amount of supply especially from U.S. companies issuing into euros, and you had this total imbalance within the market. The really interesting thing was, whilst that caused, I guess, weakness in other areas of the market as well, it was fairly acute to European investment grade. And yes, if that weakness comes through, then obviously that crowding-out effect from high yield will come through as well. But in fact, high yield remained okay. Even liquidity within high yield remained okay and, for a long period of time, was actually better than the liquidity you had within European investment grade. So I think it is fairly specific to that. The point is, I don't really expect the ECB to back away a huge amount. I can't imagine they're going to end up being anywhere near as hawkish as the Fed would be, just because we never really had amazing growth within Europe. So it's something we have to consider. I think you're absolutely right that the idea of the Fed promoting that moral hazard, it’s further away than it probably ever has been before. But again, I think markets have already priced it in to a larger extent and everyone is aware and if anything, probably overly scared about the situation.
Adam: Okay, so I think we did pretty good here. We kind of distilled rate hikes and duration and recessions and geopolitics and inflation into what's I think, a reasonably optimistic baseline from you guys. So maybe if you could close it out just taking the rest of the year looking forward. What does it feel like for the balance of the year as a high yield investor? What catalysts are you looking for? What are the return drivers? Just security selection, any big macro events, Fed news you're waiting on? How would you describe the rest of the year as investors looking forward?
Seth: I think investors in the high yield asset class are now being given an opportunity to actually achieve the name of the portfolio itself, which is high yield. It's been a while since we've been afforded yields where they are right now, which provides a nice cushion as we look forward. I think the key to markets as I look forward over the next three to six months, and I think Tom would agree with me, is really how the Fed bends this curve of inflation in the U.S. And an awful lot is priced into the market. You have to remember the market is a discounting mechanism that's already moved to where the Fed is going to be 12 or 18 months from now. We’ve already priced a lot of that in. So the question now is does the Fed meet or not those expectations that have already been priced in? If, for some reason, we see inflation come off hotter or faster than we would expect, that could be a really accretive position for risk assets as the market has already priced in a very restrictive Fed and perhaps they don't need to be as restrictive. When you look at the opposite side of it, you know, a lot of restriction has already been priced in. What if the situation is they cannot bend the inflation curve and we end up accelerating to the back half of this year, which would seem unlikely, but you know, you have to think of all scenarios. That would not be a great risk-taking environment. So I think fundamentally, companies are going to struggle with hiring costs. A lot of that has certainly been priced in to the way we're thinking about the earnings trajectory of businesses looking forward. I think the key question really is more about what the central bank does, how they're able to navigate this and whether or not they can you know, do the famous saying of a soft landing versus a hard landing. And I think that that'll be the telltale sign of how 2022 shakes out in the back half.
Tom: I'd say in that environment where so many things are changing, it feels like the cycle is going through such a big change. The ability for companies that have been used to an environment of low rates and of easy money, etc., how those companies respond to that and the differences you have not just within different sectors, but across sectors, when you start to consider things like inflation, cost price inflation, you know, energy input costs, all of these different themes that are coming through and ESG as well and how investors are now focusing on that even more than ever. How do stranded assets cope with lower financing demand? All of that leads through to security selection and the ability for those companies to see through this changing time and to be able to adapt through this changing period.
Adam: Okay, that's a pretty loaded answer, but maybe that's just some good fodder for the next episode. I think you’ve covered plenty already so thank you guys. Super helpful.
Tom/Seth: Great. Thanks, Adam.
Adam: And thanks to our listeners for joining in. If you like the show, please like or comment and if you'd like to hear more from Janus Henderson, you can find more Global Perspectives episodes on Spotify or iTunes or wherever you listen and of course, check out the Insights section of the Janus Henderson website.
*Agg is a short-form term for the Bloomberg U.S. Aggregate Bond Index (LBUSTRUU) that tracks U.S. investment grade debt.
Accretion to par: Bonds are usually redeemed at par value when they mature. For example, if they are issued at $100, they should pay back $100 par when redeemed at maturity. A bond trading below $100, say at $90, will typically begin to rise in price as it gets closer to maturity – this is called the pull or accretion to par.
Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Credit spread: The difference in yield between securities of similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Coupon: The annual or semi-annual payment (of interest) to bondholders.
Default rate: A default is the failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due. The default rate is a measure of defaults over a set period as a proportion of debt originally issued.
Duration: A measure of a bond price’s sensitivity to changes in interest rates. Duration risk is another term for interest rate risk. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa
Distress ratio: Normally described as the percentage of high yield bonds trading with a spread greater than 1000 basis points over U.S. Treasuries.
High yield tourists: Investors who do not typically invest in high yield but are temporarily attracted by a grab for yield.
High yield or junk bonds: These bonds involve a greater risk of default or price volatility and can experience sudden or sharp price swings. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon in recognition of the additional risk.
Inflation: The annual rate of change in prices, typically expressed as a percentage rate. The Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) are both measures of inflation. Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. Personal Consumption Expenditures (PCE) is the value of the goods and services purchased by, or on behalf of, U.S. residents. At the national level, the U.S. Bureau of Economic Analysis (BEA) publishes annual, quarterly, and monthly estimates of consumer spending.
Interest coverage: a measure of how easily a company can pay interest on its outstanding debt. The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes by its interest expense during a given period.
Interest rate risk: The risk that can arise for fixed income investors from fluctuating interest rates. As interest rates rise, the existing yields on fixed rate bonds become relatively less attractive so bond prices fall.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Leverage: A measure of indebtedness of a borrower. For a company this is often expressed as earnings or cash flow divided by total debt on the company’s balance sheet.
Stagflation: An economic environment where inflation is above average but economic growth is below average or even negative.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. Volatility measures the dispersion of returns for a given investment
Yield: The level of income on a security, typically expressed as a percentage rate. At its most simple for a bond this is calculated as the annual coupon payment divided by the current bond price.