Q&A on Global High Yield

How is the volatile backdrop impacting the outlook for global bonds?

The collapse of Silicon Valley Bank (SVB), among other financial institutions, and the purchase of Credit Suisse by UBS, have indeed added uncertainty to markets. More broadly, we have observed higher levels of risk aversion in the days that followed these events, with fixed income markets seeing wider credit spreads and meaningfully lower U.S. Treasury bond yields. In addition, certain parts of the market have come under considerable pressure—in particular, investors have re-evaluated the risks associated with subordinated bank debt following Credit Suisse’s Additional Tier 1 (AT1) bonds being written down. As a result of these developments, expectations for future U.S. Federal Reserve (Fed) rate hikes have moderated given the increased financial risks, and markets are predicting possible monetary policy easing later in 2023. If the Fed does eventually pause policy, and the strength of the U.S. dollar moderates, this could provide some impetus for a number of the Asian central banks to employ a less hawkish stance.

Following SVB’s collapse, what measures were taken in terms of your approach to the bond market? What have investors been most concerned about?

Across our high yield credit strategies, our direct exposure to investments in banks is minimal as we primarily focus on lending to cash flow generating corporates and generally utilize ex-financial benchmarks. As such, our emphasis has been on better understanding the more indirect market implications as a result of the recent market developments. For example, as we look ahead, higher spreads and lower equity prices for financials will likely translate into a higher cost of capital for the sector. If this persists, it is likely to have an impact on financials earnings, the availability of credit, and, all else unchanged, tighter financial conditions and lower economic growth. In this scenario, some borrowers will be more affected than others—for example, smaller and highly leveraged companies, and certain sectors such as real estate (which are more dependent on regional bank lenders than other sectors) are likely to be more impacted. That said, we have also seen credit spreads widen reasonably over the past month. As with past periods of uncertainty, we continue to operate our highly rigorous bottom-up oriented investment process with emphasis on credit specific drivers of returns, relative value considerations, and prudent risk management to identify attractive opportunities, which periods of volatility such as now typically produce.

Investor concerns have been varied, and have included topics such as assessing their exposure to the banking sector, inquiring about broader contagion risks, and better understanding regional nuances across bank regulations, to name a few. Within the APAC region, clients have also been concerned about the AT1/CoCo market, as that has been a popular allocation for some investors given the higher yields on offer and exposure to what was perceived to be low risk, large banking institutions.

With SVB’s collapse and ongoing inflation concerns, more global investors are turning to bonds. Can you explain why?

Even prior to the SVB situation unfolding, we had started to see investors starting to increase their allocation to bonds—especially given the higher starting yields on offer following the significant market repricing that took place in 2022 and even earlier this year. In addition, at a high level, bonds appear to be more favorable against a market backdrop of slowing growth, softening inflation and tighter financial conditions. Following the recent banking events, bond markets have rallied sharply as expectations for future rate hikes have reduced significantly, and as such, future returns will be driven by how the market evolves relative to some of these expectations that are now already priced into markets. As we look ahead, an environment where overall growth and company earnings and profit margins are likely to be more challenged, should generally be more constructive for bonds. However, careful attention on relative valuations will be required, as well as on which segment of the underlying bond and/or equity markets you have exposure to, along with what else comprises your portfolio.

Does it make sense to consider riskier assets such as high yield in a volatile market?

Timing markets precisely is extremely challenging to do, and often times, time invested in the market can be just as important when trying to harvest risk premia and compound returns over time. While it is true that high yield strategies carry greater risk, the current yield/income profile on offer is also more compelling to help compensate for the higher credit risk being undertaken. At the same time, the credit quality profile of the high yield bond market has improved significantly over the past 15 years, which should add further resilience to the overall market. Given the large size of these markets, they also present ample opportunities for alpha generation potential.

In terms of defaults, while default rates across high yield have remained very low over the past couple of years, we do expect them to rise going forward. However, we expect defaults to be closer to longer-term historical averages, given the higher quality nature of the market today, the strong starting (albeit deteriorating) credit fundamental levels, and limited near-term re-financing needs. The current yields on offer also continue to provide compelling total return potential over a medium-term time horizon, especially relative to the growth and earnings-sensitive equity markets, which can face greater downside in the event of an economic slowdown. One of the key benefits of high yield bond investing is the regular coupon payments on offer—this income stream provides resiliency from a total return perspective.

In addition, at current market valuations, high yield bonds are trading at significant discounts of 10-15%, and this provides further capital appreciation prospects for issuers that will eventually pay back their debt. For example, the global high yield bond market is trading at an average price of 85.99 and a yield-to-worst of 8.77. Meanwhile, within high yield, senior secured bonds provide exposure to credit securities that reside at the top of the capital structure, and that have historically offered better principal preservation (higher recovery rates) in the event of a credit impairment situation. This additional characteristic may be preferred in a volatile market. Senior secured bonds currently trade at an average price of 87.62 and a yield-to-worst of 9.05%.¹

In the current market, how should investors allocate between bonds and equities?

When assessing asset allocation decisions between bonds and equities, it is crucial for investors to take into account various considerations such as risk tolerance. That being said, with interest rates having risen significantly over the past year, there has been heightened market volatility across most financial assets. Several fixed income markets, in particular those with higher interest rate sensitivity (i.e. a longer duration) profiles, have re-priced materially lower, with bonds now trading at heavily discounted levels. Given the lower bond prices and higher yield prospects, these markets are positioned much more favorably going forward.

Overall, the higher starting yield levels for fixed income, as well as expectations for moderating growth due to tighter financial conditions, suggest that bond markets today look compelling relative to the growth and earnings-sensitive equity markets. In our view, this will likely eventually lead to capital re-allocation across asset classes.

1. Source: Bank of America. As of March 20, 2023.

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