While the starting yield may now look much less attractive, high-yield bonds continue to offer investors a positive yield that exceeds the near-zero return on investment-grade bonds. As such, high-yield debt stands out relative to the negative yields that go with many government bonds.
In addition, we believe high-yield debt will continue to benefit from the extensive support provided by many central banks and governments and the financial repression that results from large-scale quantitative easing by central banks. This has driven market interest rates to rock-bottom levels and encouraged companies in search of cash to tap the market for cheap finance.
We also see the unencumbered availability of liquidity as a buffer against default risk. Defaults have so far mainly been limited to a handful companies that were already struggling before the COVID-19 crisis.
Some companies that were close to default have been able to extend the maturity of their bonds or have received capital injections and have thus been able to postpone defaulting.
The outlook could change in 2022 or 2023 if the liquidity taps are then turned off, or there is not enough of a recovery in demand for heavily indebted companies.
Targeting the pockets of value
We believe there is still value in areas that other investors are not necessarily interested in, or at least now, because they want to see actual signs of economic recovery before they invest.
These areas are potentially somewhat less liquid and less well understood, so it is crucial to conduct robust credit research before investing in order to ensure the company can pay the coupon on their bonds and ultimately redeem it.
In our view, the rewards for those ahead of the curve can be quite handsome. We see 2021 as a year for alpha managers. That is, it could be a good year for high-yield bond portfolio managers who are willing to accept that returns will be earned by trading the range in which risk premiums will move, even if that range has become quite tight, and who are ready to buy the dips.
Where are the opportunities now?
We see opportunities in the following areas:
- In industries that stand to benefit from reflation, such as metals, commodities and energy
- In the industrial sector rather than the services sector; in industries that have seen a rebound including basic industries, capital goods and automotive
- In businesses that have undergone a debt restructuring, so companies that have cleaned up their balance sheets by paying down debt or boosted equity levels
- In the convertible bond market, namely in bonds with an embedded equity option that is out of the money where there is scope for a positive catalyst to trigger price gains
- Among the ‘rising stars’, i.e. companies heading for an upgrade of their credit rating to investment-grade, where credit risk is falling and whose bonds have the potential to provide high single-digit returns.
By assessing and reassessing the investment universe and adjusting the portfolio regularly, we believe it is possible earn attractive absolute risk-adjusted returns and also do well against the benchmark. That is what we did in 2020 and we aim to continue this year.
Riding the waves, even when they are high
2020 was a very challenging year, yet active portfolio managers were able to set themselves apart. We did better than many of our rivals with our agile approach. In fact, we had already started to sell riskier holdings by mid-February after a strong start to the year. This meant that the portfolio was quite resilient in the broad market selloff in March. This left us in a good position to buy on the dips.
We opted for bonds in the traditionally safer sectors such as telecoms, healthcare and packaging companies, but that opportunity set disappeared quickly. We then switched to buying the more cyclical sections of the market, notably the ‘fallen angels,’ so the companies whose credit ratings had been downgraded to high-yield.
In automotive, for example, we earned some of the best yields of 2020. Later in the year, we saw opportunities in the ‘vaccine trade’, buying deeply discounted bonds in very COVID-disrupted industries such as airlines and other consumer-facing companies.
Volatility was at times extreme in 2020 and risk premiums skyrocketed. The spreads of European high-yield bonds over investment-grade or sovereign debt have come off. However, we believe our approach - a total return focus on liquid bonds of robust companies offering good carry - will continue to pay off.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.