Market conditions have been tough, almost across the board. What’s going on in high yield credits?
“A lot has changed so far this year. The high yield bond market had a strong start to the year, with spreads close to all-time tights. At that point we foresaw the end of the cycle – government stimulus was coming to an end, and we anticipated a rise in inflation – and therefore kept betas at underweight levels. That view is now playing out quite rapidly. Policy rates are moving higher, equities are down and credit spreads have moved up. On the latter, we’re finally seeing spreads and yields that are well above average – at 8% in Euro high yield and 9% in US high yield – and that are interesting again.”
“As a team – which includes the other high yield portfolio managers, Roeland Moraal and Christiaan Lever – we have now more or less closed the underweight and are ready to increase beta further as spreads widen – which is probable in an environment of high volatility where valuations tend to overshoot. That is driven by the fact that we think inflationary forces are so intense that the Fed and the ECB will need to hike rates more. In fact, we expect rates will go up to the point where demand will be killed.”
Is a recession inevitable?
“Yes, at this point we believe it is. Because that's the only solution for inflation: to throttle demand and force the economy into a recession. Central bank rate-hike cycles typically end in recession and it will be the same this time around.”
Given this outlook, what’s your high yield investment strategy?
“What matters is what other investors are going to price in. Our contrarian approach is to predict what others will predict, and to be one step ahead. Once the expectation of recession has become consensus, and before it really happens, we start buying. The performance will follow, when the pricing of the surviving high yield assets recover.”
How concerned are you about defaults if this scenario were to play out? Are you watching default rates closely?
“Default rates are still low. Bear in mind that default rates are not a predictor of return, but a lagging indicator. In tough times, the first thing to happen is that spreads widen. As a result, some companies become unable to fund and then end up defaulting. By that time it’s already in the price. But what you are seeing now is that distressed rates are going up; these are the companies that will default in around six to twelve months.”
How is that measured?
“The distress rate is the percentage of companies that trade with spreads above 1,000 basis points. If you have to pay more than 10% over government bonds to fund your business, you clearly are not in a position to refinance.”
It sounds daunting: inflation, recession. What’s your assessment of the world you’re operating in?
It’s a difficult environment to be in. We’ve had 20, 30 years of deflation and globalization, during which companies were the big beneficiaries, because they could outsource part of their production and rely on cheap labor. We’re now seeing a reversal of some of these trends. The Covid-19 crisis and the war in Ukraine have shown policymakers how vulnerable the global supply chain is and how risky it can be to be dependent on regimes that don’t share our Western values.”
“Western economies are now seeking greater independence, especially in strategic sectors. And companies want supply chain security, so they're no longer looking only at the cheapest option. That means that the period of disinflation is behind us. Onshoring or re-shoring, geopolitical risk and demographics will collectively contribute to a more inflationary environment, which could be good for workers but not necessarily for capital markets. In short, it's a new environment. And, in this, there will be winners and losers.”
Overall, a much more volatile world, then?
“Yes. And remember that increased volatility is a risk for credit investors. We are mainly concerned about avoiding the losers because they imply losses. In credit investing, there is no upside from the winners; they pay their coupon and you get your money back. To function amid this volatility we need higher compensation. That's why we need spreads that are well above average.”
“The good news is that markets will reprice and will get through this. It means you lose money in the transition phase, until you reach valuations where risks are priced, and then you're good to go again. We are now a big part into that transition. And it’s very violent. That's why markets are down so much – in equities, in rates, in credits. So you need to price the new equilibrium. And once you're there, it's fine.”
What’s your motto for making it through this phase?
“Be patient. Don't be lured into the market too quickly. Wait for that opportunity. And, as we’ve learned from past experience: when the market’s in a really bad state, it's time to go in.”
How hard is it for you to do that – to avoid the temptation of following the consensus? You've been doing this for, what, 25 years?
“Since 1998. It's difficult, because it's natural to anchor to the recent past. To think that the market is really cheap now, because we were 200 bps tighter last year. Instead, to get a proper understanding of valuations, you really need to take a long-term perspective. It’s a matter of looking not only at the 2000s, but also at the 1970s and 1980s, which were times of low economic growth, very high inflation and the Cold War.”
“Sometimes such a long-term perspective has a price. We had a period of underperformance in 2021 because of our underweight position, because governments were rescuing companies. But we remained convinced of the importance of being conservative and we stuck with our view. That confidence and patience paid off, and we are top of the league tables again because of what has happened in markets in recent weeks.”
What is the biggest risk to your strategy?
“The biggest risk for this strategy, of course, is that our view doesn't play out. That could happen if, for example, governments again come to the rescue, to bail out companies. Because, for our view to play out, we need a clean-up of the market, a healthy process of defaults, and for markets to do their work. The last time we had a proper clean-out was during the global financial crisis, in 2008-2009.”
“And for the high yield market itself, the biggest risk would be a very high default rate, caused by the market simply being very weak for a lot of companies.”
“The time of easy money is over. Companies should realize that and should lower leverage now. If you don't have the free cash flow to do that, you would need to restructure the hard way, which means a default. The risk is that the market falls hard and that returns are so negative that investors lose confidence and throw in the towel. If that happens, it could be an ideal buying opportunity.”
“That happened in early 2009. People thought credit was dead forever. That things would never be the same. Professionally, I look forward to that sentiment reoccurring, because that’s when you can really make money as an investor.”
And is that what you did in 2009?
“That’s when we started buying, absolutely. There were clients that were calling us and saying: sell everything, it doesn't matter what it is. You then get valuations that are completely decoupled from fundamentals. You can make money in that environment of maximum panic – provided you have the guts. It's very easy to be bearish at that moment because it looks like the world is about to collapse.”
“And we have seen, over the last 25 years, that being very contrarian has paid off. The track record is great, longer term. So, we have the courage to stick to our convictions. That's the nice thing about this work. I always enjoy these kinds of markets; they're opportunities.”