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Over the course of years, high yield (HY) returns emerged as key contributors towards portfolio returns. Expectedly, the first quarter of 2020 was conditioned by the remarkable volatility brought about by the pandemic. Historically, the HY asset class had a high correlation to the more risky assets, such as equities, and inevitably the uncertainty in March 2020 pushed those correlation levels higher. Analysis of the asset class per se focused predominately on the survivability mode, and liquidity analysis was imperative to ensure that a company had the ability to sustain its debt servicing through all available sources of liquidity. Today we’re moving from the survivability mode to a more stabilised scenario and we believe that the following factors will conditioned HY returns.
Despite the pandemic brought about numerous downgrades, with falling angels (bonds transiting from the investment grade space to high yield) increasing historically in numbers, this had a positive impact from an asset quality perspective on the HY universe. Indeed, looking at both the Europe HY market and the U.S. HY market, we’ve seen an uptick in BB rated bonds as at March 2021 when compared to February 2020. BB rated bonds within Europe now account for 72 percent as opposed to 69 percent, while within the U.S. space the same rating bucket accounts 54 percent when compared to 49 percent in February 2020. The lower tier rating such as CCC remained broadly unchanged. Furthermore, also as expected rating agencies revised at the time their outlook to negative given the remarkable uncertainty. Nevertheless, lately we are experiencing again the opposite transition-rating agencies changing their outlook from negative to stable and in certain cases from stable to positive. Again, this is a signal of asset quality improvement, especially in specific sectors which have emerged stronger over the course of 2020. The shipping industry is a pure example with several companies experiencing rating upgrades.
The asset class per se, is trading at record low decade yields, and rightly so investors are questioning the levels of risk-adjusted returns at this point. Inevitably, the tight yields were conditioned by the wave of economic support by both fiscal and monetary politicians and thus one might question whether the asset class per se still makes sense as an investment rationale.
Despite we are conceptually mindful of the very tight yielding environment, we strongly believe that pockets of value are still one of the attributes towards performance. Indeed, through our bottom-up analysis over the past months we’ve managed to identify value stories which are more aligned to the re-opening of the economy and other areas which are also more cyclical in nature. Practically speaking, we identified value in HY cruise port operators, U.S. airlines and auto-parts names, which were offering huge relative value on the basis of thin liquidity and other structural specific issues will should ultimately be sorted in the coming quarters.
Theoretically speaking, the fixed income market will be pinched by upward moves in benchmark curves. Currently markets are betting to when policy support will be reduced and this has creating jitters over the past couple of days. Rightly so, inflationary expectations have spike and as discussed previously this is understandable, given the base effect, the supply disruptions and also the expectations of an economy re-opening at full speed which should translate in a remarkable increase in pent-up demand. With this, we expect to see potential uncertainty regarding what happens to underlying rate curves. However, in our view the sustainability of those inflation numbers will be a real test in the last quarter of 2021 and 2022. Yet again here, we need to analyse the fixed income asset class in segregation. For HY investors, we view this as a mild concern, not a structural one. If those inflationary expectations translate into the real economy, this would imply that the economy is now healthier and thus as a HY credit investor I would be more comfortable as this would imply better revenue streams and thus less risk in terms of debt servicing. Moreover, when looking across the fixed income opportunity set, HY is relatively short duration, when compared to sovereign bonds and the investment grade space, and higher yielding. Therefore, the relatively lower duration, in addition to the higher coupon will be able to absorb the normalisation of the rate curve that may occur, namely in the U.S.
Thus in our view, upcoming monetary decisions should not be seen as a source of negative returns but ultimately of possible volatility, which could trigger opportunities in the short-to-medium term.
Overall, we believe that the HY class still offers opportunistic value if a very thorough and diligent bottom-up approach is in place. Thus investors should be well aware that being selective is crucial in obtaining the desirable returns.
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