Jack Holmes co-manages the Artemis Funds (Lux) – Global High Yield Bond fund alongside David Ennett
Financial commentators love to use the word ‘unprecedented’. In most cases it is used too easily, but the last few years have seen events – notably the Covid-19 shutdowns of 2020 and resulting fiscal and monetary support of a scale that has never been seen before – that do deserve the adjective.
Following that remarkable episode, we are now in the midst of a period of growth, inflation and central bank tightening that – while perhaps not unprecedented – are most certainly a stark break with the trends seen over the period since the global financial crisis.
So what does this period of robust economic growth, elevated inflation, and central bank tightening mean for high-yield bonds?
Well, unlike many parts of the bond market, we believe the high-yield asset class is well set up for this environment. At its core, a high-yield bond is an instrument that converts ‘real world’ corporate cash flows into coupons paid to those investors funding those same cash generating activities. More than $2.5 billion of cash generated by global corporates is received by the global high-yield market, each week, in the form of these coupons. We believe these flows provide a very attractive source of return in today’s environment for a number of reasons:
- High yield has a low duration, or sensitivity to movements in government bond yields. This means that tightening central bank policy via rate increases should affect high-yield considerably less than other parts of the bond market, such as investment-grade or sovereign bonds, which have a greater sensitivity to rate movements.
- Attractive yields or current income: hedged into GBP, the global high-yield index currently provides a yield to worst – the most conservative measure of yield – of 6.9% (7.4% in USD, and 5.0% in Euros). To put this in context, the trailing yield on the MSCI World Equity Index stands at 1.9%, 10-year benchmark government bonds yield between 0.2% and 2.7%, and global investment grade corporate bonds yield 3.7% (hedged to GBP; 4.2% hedged to USD and 1.8% hedged to Euros).*
- Anchored to corporate profitability: the vast majority of the income the high-yield asset class provides comes from the ‘credit spread’, the additional yield investors earn taking risk by investing in corporate bonds rather than ‘risk-free’ government bonds. How large this premium is is tied to corporate profitability, which is in turn tied to economic growth. With real economic growth looking robust over the next few years, the risk of defaults – and the potential for the high-yield asset class not delivering the income it promises – is historically low.
*Source: Bloomberg and ICE BoAML. As at 25 April 2022.
In addition to these attractive near-term features of the asset class, we cannot ignore the structural changes that have occurred in it over the last 20 years.
While other asset classes have seen their duration increase and their credit quality deteriorate, the global high-yield market has actually seen the opposite happen. As the chart below demonstrates, the share of the high-yield market in the highest quality bracket (BBs) has increased meaningfully, while the share of CCC & below rated bonds (the lowest quality bracket) has more than halved since the period around the global financial crisis.
High Yield has increased in quality drastically over the past 25 years
The chart below shows another measure of risk – the duration, or sensitivity of each asset class to movements in yields. The decline in high yield’s sensitivity to government bond yield changes, alongside the significant growth in investment grade and government bond duration stand in stark contrast.
High Yield's sensitivity to yield moves has fallen while other major markets have risen dramatically
So given these attractive market characteristics, why would you not simply buy a cheap passive or quasi-passive solution?
Besides not always being cheaper**, we believe that by virtue of their construction they may struggle in a changing liquidity environment. Passive high-yield strategies weight their exposures by the amount of debt borrowed by issuers. This is a stark contrast to equity indices which are weighted by market capitalisation, which is a decent proxy for how fundamentally valuable a company is. Lending to companies in proportion to their desire for debt is not.
We believe that the reverse of quantitative easing will provide a significant boost for our style of high-conviction active management. Unprecedented monetary policy support being withdrawn against the backdrop of buoyant global growth will likely result in a return of dispersion to the market.