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The high yield bonds market offers a unique set of opportunities in an environment of low interest rates, but you need to know where to look, says portfolio manager Sander Bus.
The nature of the high yield market means it is more important to avoid the losers than pick the winners, requiring a contrarian and unconstrained approach, he says. This enables investors to get market-beating returns as global interest rates remain at, or close to, historical lows.
High yield bonds are those issued by companies with credit ratings below investment grade, meaning they carry higher risk than investment grade credits, but have higher returns to compensate for that risk. The companies issuing them tend to fall into one of three categories: they are relatively young and so don’t have established credit records; they are engaged in higher-risk industries such as oil exploration; or – and quite commonly – they operate in a more mature sector where they use leverage to create a more attractive return on their capital.
“The market offers an ever-expanding opportunity set as the kinds of companies that issue them differ greatly on a regional and sectoral level,” says Bus, who has been involved with our high yield fund since its inception in 1998 and is a leading authority on the asset class.
“High yield energy companies for example have different risk and reward metrics to those in the consumer goods sector, while there are big differences in corporate approach – including cultural attitudes to levels of leverage – between the US and Europe. This allows diversification across the high yield spectrum and means that we need to adopt a truly globalized approach to investing.”
Buying the right bonds by using this kind of active approach is important, because the overall market is often affected by prevailing macroeconomic forces – sometimes irrationally. For example, 2016 saw a number of factors impacting sentiment for high yield (and other securities), from fears of a Chinese slowdown to the Brexit referendum vote. However, these ‘wobbles’ also present opportunities, particularly as economies become more dislocated due to different central bank policies, Bus says.
“Regional disparity between the US and Europe is an important source of opportunities for active investors like ourselves,” he says. “Rarely do economic cycles move in tandem, and these differences allow us to distinguish between the type of exposure that we like to take in any geographic area. The US economy, for example, is moving towards a later stage in its cycle compared to the Eurozone, with the Fed signaling its willingness to tighten monetary policy while the ECB continues to loosen.”
‘Rarely do economic cycles move in tandem’
“Currently, this is a reason for a more cautious stance towards US credits, particularly if the risk premium (spread) is not compensating for this. The issue is compounded by the fact that US companies currently tend to be more leveraged than those in Europe, where company managements tend to still have a strong recollection of the euro crisis era and remain more conservative in their attitude to taking on debt, including the issue of high yield bonds. As any investment carries risk, it is therefore vital to have a truly global approach in order to select the most compelling investment cases available to an investor.”
Bus says there can also be major regional differences within sectors, of which the financial industry is a prime example. “Many weaker banks are still recovering from the financial crisis, and certain Eurozone banks remain weak, overburdened with non-performing loans, as the 2016 Italian banking crisis revealed,” he says. “But there are plenty of exceptions – the recapitalization of EU banks has created a vibrant market for ‘hybrid’ bonds, and subsequently the subordinated paper issued by strong European banks is a highly attractive category.”
Bus says it is essential to be contrarian and don’t ‘follow the herd’. This may mean, for example, buying bonds in unfashionable sectors or areas, but with room for returns, without being constrained by borders. “We always prefer to be buying when others are selling, and selling when others are buying,” says Bus.
“And you need to establish whether an exogenous factor that prompts a selling spree actually affects the underlying fundamentals of investee companies. For example, high yield spreads were spooked by the Brexit vote, which sent most asset prices downwards, but it is important to step back and look at the valuations, technicals and fundamentals before rushing to judgement. For most high yield companies, whether or not the UK is in or out of the EU makes no difference to their business models, and investment should therefore be made according to facts, not sentiments.”
“The total return outlook is very positive for investors who are able to withstand day-to-day volatility – which high yield investors should be able to do anyway – and not be swayed by macroeconomic and/or sentiment factors that often have no bearing on the underlying securities.”