High yield - navigating a slowdown

22/01/2019

Download

​Credit managers Tom Ross, Thomas Hanson and Seth Meyer contrast the current backdrop for high yield with previous tightening cycles, indicating that dispersion can be the friend of the active investor.

 
Why has the US Federal Reserve (Fed) been hiking rates? It seems a peculiar question to ask when so much of the focus is on the future path of interest rates. It is a valid question, however, because in its answer lies the kernel of whether high yield bonds are attractive.
 
From a credit perspective, we should take some comfort from the fact that the Fed is hiking because US economic data is robust – wage growth is at 3.2% year-on-year (Dec 2018), unemployment is low and the manufacturing purchasing manager index at 54.1 (Dec 2018) remains well above the 50 expansion level. Tainting matters is the fact that global growth is slowing and how the Fed responds to this will be of vital importance to markets.
 
While the Fed has lowered its trajectory for rate hikes, what was clear from its December 2018 meeting was a determination not to let equity market prices dictate its actions, with rate rises still pencilled in for 2019, although the Fed Chairman Jerome Powell struck a more conciliatory tone at the start of 2019. With this in mind, should high yield investors be worried about the sharp fall in equity markets in late 2018? On the one hand, markets had become frothy so it was a healthy correction. On the other, high yield and equity tends to have a closer correlation than other areas of fixed income, both being sensitive to corporate conditions. It is difficult to see high yield rallying against a declining equity market, although declines in high yield are typically well below those of equities. In 2008, for example, US high yield fell 26% against a fall of 37% in the S&P500, high yield also recovered more impressively the following year. Moving further back in time to the dot-com bust, the S&P500 fell for three years (2000-2002 inclusive): equity returns were consecutively -9%, -12%, and -22% against US high yield returns of -5%, +5% and -2%.
 
Figure 1: US high yield bond and equity annual total return
1
Source: Thomson Reuters Datastream, 31 December 1999 to 31 December 2018, ICE BofAML US High Yield Total Return Index, S&P500 Total Return Index, USD.
Past performance is not a guide to future performance
 
The danger agitating investors is whether the Fed will overshoot and cause a recession. As Figure 2 shows, previous tightening cycles have typically presaged an economic downturn, although 1994/95 showed this need not be the case, while the lead time from the start of tightening to a recession can stretch into years.
 
Figure 2: Fed tightening need not always lead to a recession
 2
Source: 30 November 1986 to 30 November 2018, FRED US recession dates, Federal Reserve federal funds target rate, Moody’s US trailing 12m speculative grade default rate, ICE BofAML US High Yield (H0A0) spread-to-worst versus government.
 
Currently, earnings and economic expansion are still strong but we are under no illusions – they can often look like this a year or two ahead of a downturn. Consumers and banks were over-borrowed in the last economic cycle. This time round they are better behaved, with the US household debt to income ratio substantially below its 2007 level and back to 2001 levels. Banks’ capital ratios are also far stronger than before the financial crisis.
 
Corporate leverage and government borrowing, however, have both risen. Of more concern is corporate borrowing. Non-financial corporate debt is at peak levels, although this is driven by investment grade borrowers. Interestingly, US high yield companies in aggregate have been de-leveraging in the last two years and net supply of high yield bonds has shrunk for the third year in a row. This positive fundamental and technical backdrop is mirrored across the Atlantic where the European high yield bond market has seen net debt ratios fall since 2013 and there has been no growth in size of the high yield market in the last few years as companies have – in common with the US – shown a preference for leveraged loans and direct borrowing. In fact, the Fed’s determination to raise interest rates and shrink its balance sheet may be a signal that it is more worried about a deterioration in underwriting standards in these areas of non-bond lending, which its easy policy conditions had helped propagate.
 
Re-leveraging among corporate borrowers, however, can take two forms: active, where the proceeds of additional borrowing are used for bond-holder unfriendly activities such as debt-fuelled mergers and acquisitions or share buy-backs; or passive, where declining earnings erode the denominator in the net debt/EBITDA1 ratio.
 
The swelling of the BBB market in the US and Europe means there is concern that higher-leveraged investment grade issuers may be downgraded to high yield if earnings and cash flows come under pressure. This could cause yields to climb as the relatively smaller high yield market seeks to absorb a wave of new arrivals. This is a threat we are cognisant of, although it is not wholly unwelcome since downgrades often bring a different type of issuer.
 
The rise of passive funds within fixed income also means any shakeout should be more advantageous for active managers, since they will be in the strongest position to discriminate among holdings. Typically, when a bond is downgraded from investment grade to high yield, there is a window of opportunity to buy at a price that is technically depressed by forced selling and often recovers subsequently (see Figure 3).
 
Figure 3: Price performance of bonds following a downgrade (2003-2016)
3
Source: Morgan Stanley Research, Bloomberg, Markit, February 2016. Note: Each colour band represents one decile; dark line represents sample median. Based on a universe of 89 fallen angel issuers representing 212 euro-denominated bonds between 2003 and 2016.
Past performance is not a guide to future performance.
 
We can also expect – and are seeing – greater single name and sector dispersion particularly in European high yield as markets reflect the late-cycle environment and fundamentals begin to take on greater importance. Again, this is an environment that can offer opportunities for active investors.
 
So 2019 looks to be a challenging market but with spreads having widened considerably in the second half of 2018, the high yield market is already pricing in a more difficult period. Within European high yield, for example, the average spread on B rated bonds was 724 basis points at 31 December 2018, more than 200 basis points above their levels in December 2007 and 70 basis points above the 20 year average2. From a value basis, we would argue that European high yield looks more attractive than US high yield and Europe remains earlier in the cycle than the US. The rest of the world has struggled to decouple from the US, so what happens in the world’s biggest economy is likely to create ripples more broadly. For that reason, we will be keeping a keen eye on the Fed.
 

1EBITDA= earnings before interest, tax, depreciation and amortisation.
2Source: ICE BofAML Bloomberg European Currency High Yield B Index (HP20), govt option-adjusted spread.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

For promotional purposes.


Important information

Please read the following important information regarding funds related to this article.

Janus Henderson Horizon Euro High Yield Bond Fund

This document is intended solely for the use of professionals and is not for general public distribution.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Any investment application will be made solely on the basis of the information contained in the Fund’s prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the Fund’s prospectus and key investor information document before investing. A copy of the Fund’s prospectus and key investor information document can be obtained from Henderson Global Investors Limited in its capacity as Investment Manager and Distributor.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Past performance is not a guide to future performance. The performance data does not take into account the commissions and costs incurred on the issue and redemption of units. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

The Fund is a recognised collective investment scheme for the purpose of promotion into the United Kingdom. Potential investors in the United Kingdom are advised that all, or most, of the protections afforded by the United Kingdom regulatory system will not apply to an investment in the Fund and that compensation will not be available under the United Kingdom Financial Services Compensation Scheme.

Copies of the Fund’s prospectus and key investor information document are available in English, French, German, and Italian. Articles of incorporation, annual and semi-annual reports are available in English. Key Investor document is also available in Spanish. All of these documents can be obtained free of cost from the local offices of Janus Henderson Investors: 201 Bishopsgate, London, EC2M 3AE for UK, Swedish and Scandinavian investors; Via Dante 14, 20121 Milan, Italy, for Italian investors and Roemer Visscherstraat 43-45, 1054 EW Amsterdam, the Netherlands. for Dutch investors; and the Fund’s: Austrian Paying Agent Raiffeisen Bank International AG, Am Stadtpark 9, A-1030 Vienna; French Paying Agent BNP Paribas Securities Services, 3, rue d’Antin, F-75002 Paris; German Information Agent Marcard, Stein & Co, Ballindamm 36, 20095 Hamburg; Belgian Financial Service Provider CACEIS Belgium S.A., Avenue du Port 86 C b320, B-1000 Brussels; Spanish Representative Allfunds Bank S.A. Estafeta, 6 Complejo Plaza de la Fuente, La Moraleja, Alcobendas 28109 Madrid; Janus Henderson Investors (Singapore) Limited, 138 Market Street, #34-03 / 04 CapitaGreen Singapore 048946; or Swiss Representative BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich who are also the Swiss Paying Agent. RBC Investor Services Trust Hong Kong Limited, a subsidiary of the joint venture UK holding company RBC Investor Services Limited, 51/F Central Plaza, 18 Harbour Road, Wanchai, Hong Kong, Tel: +852 2978 5656 is the Fund’s Representative in Hong Kong.

Specific risks

  • This fund is designed to be used only as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • The value of a bond or money market instrument may fall if the financial health of the issuer weakens, or the market believes it may weaken. This risk is greater the lower the credit quality of the bond.
  • If the Fund or a specific share class of the Fund seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Any security could become hard to value or to sell at a desired time and price, increasing the risk of investment losses.

Risk rating

Janus Henderson Horizon Global High Yield Bond Fund

This document is intended solely for the use of professionals and is not for general public distribution.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Any investment application will be made solely on the basis of the information contained in the Fund’s prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the Fund’s prospectus and key investor information document before investing. A copy of the Fund’s prospectus and key investor information document can be obtained from Henderson Global Investors Limited in its capacity as Investment Manager and Distributor.

Issued in the UK by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Past performance is not a guide to future performance. The performance data does not take into account the commissions and costs incurred on the issue and redemption of units. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

The Fund is a recognised collective investment scheme for the purpose of promotion into the United Kingdom. Potential investors in the United Kingdom are advised that all, or most, of the protections afforded by the United Kingdom regulatory system will not apply to an investment in the Fund and that compensation will not be available under the United Kingdom Financial Services Compensation Scheme.

Copies of the Fund’s prospectus and key investor information document are available in English, French, German, and Italian. Articles of incorporation, annual and semi-annual reports are available in English. Key Investor document is also available in Spanish. All of these documents can be obtained free of cost from the local offices of Janus Henderson Investors: 201 Bishopsgate, London, EC2M 3AE for UK, Swedish and Scandinavian investors; Via Dante 14, 20121 Milan, Italy, for Italian investors and Roemer Visscherstraat 43-45, 1054 EW Amsterdam, the Netherlands. for Dutch investors; and the Fund’s: Austrian Paying Agent Raiffeisen Bank International AG, Am Stadtpark 9, A-1030 Vienna; French Paying Agent BNP Paribas Securities Services, 3, rue d’Antin, F-75002 Paris; German Information Agent Marcard, Stein & Co, Ballindamm 36, 20095 Hamburg; Belgian Financial Service Provider CACEIS Belgium S.A., Avenue du Port 86 C b320, B-1000 Brussels; Spanish Representative Allfunds Bank S.A. Estafeta, 6 Complejo Plaza de la Fuente, La Moraleja, Alcobendas 28109 Madrid; Janus Henderson Investors (Singapore) Limited, 138 Market Street, #34-03 / 04 CapitaGreen Singapore 048946; or Swiss Representative BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich who are also the Swiss Paying Agent. RBC Investor Services Trust Hong Kong Limited, a subsidiary of the joint venture UK holding company RBC Investor Services Limited, 51/F Central Plaza, 18 Harbour Road, Wanchai, Hong Kong, Tel: +852 2978 5656 is the Fund’s Representative in Hong Kong.

Specific risks

  • This fund is designed to be used only as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • The value of a bond or money market instrument may fall if the financial health of the issuer weakens, or the market believes it may weaken. This risk is greater the lower the credit quality of the bond.
  • If the Fund or a specific share class of the Fund seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Any security could become hard to value or to sell at a desired time and price, increasing the risk of investment losses.

Risk rating

Share

Important message