Q&A on High Yield

What is your outlook for the global high yield bond market?

From a fundamental standpoint, high yield issuers appear to be on solid footing. Company earnings, revenues and cash flows are expected to remain well supported by the resurgence in consumer demand this year and into 2022. While inflation concerns linger, and were escalated with the U.S. Federal Reserve’s (Fed) unexpectedly hawkish turn in June, many companies have so far been able to push prices through to the consumer. 

It is also worth noting that the quality of the global high yield bond market is significantly higher today relative to history, with BB rated credits making up nearly 60% of the market, up from 35% in 2007.¹ This uptick in quality is due in part to last year’s record fallen angel activity, as a number of large, investment grade-rated companies were downgraded into high yield as the pandemic took hold. In the U.S. market in particular, as much as US$200 billion of high yield debt looks likely to migrate back to the investment grade market going forward, which presents opportunities to identify candidates for upgrades.²

From a valuation perspective, while high yield bond credit spreads have tightened in recent periods, they remain wider than all-time tights—and more importantly, look favorable relative to higher-rated corporates. Active security selection also remains a critical source of potential value add in the current market environment. Given the large scale of our global high yield team, we are able to undertake rigorous bottom-up analysis on nearly every opportunity in the market. This approach positions our team to capture the best available relative value opportunities, not only across regions but also across sectors and companies.

From a supply-demand perspective, with capital markets still open, high yield bond issuance has surged in recent periods. However, debt refinancings have accounted for a large portion of this, with many companies looking to get ahead of potential rate increases down the road. This has pushed out impending debt maturity walls several years, easing near term re-financing related risks. Balancing the strong supply picture, demand also continues to be robust, as the market remains firmly in search of yield in the current low interest rate environment.

Finally, with expectations for continued economic growth coming out of the pandemic, it is reasonable to expect that the Fed will at some point move toward tapering, and rates will eventually rise. That said, high yield bonds, while fixed rate assets, still look relatively well-positioned in a reflationary environment given their shorter duration relative to other longer duration fixed income asset classes. If periods of rising U.S. Treasury yields are associated with higher growth and inflation prospects, as was the case during the first half of 2021, this type of a reflationary environment is typically a positive backdrop for high yield bond markets. We can observe this from the low and often negative correlation in total returns between the high yield and government bond markets.
 

Where do you see most value across sectors, duration and credit ratings?

Our global high yield strategy continues to offer an attractive premium, or higher yield/spread levels, versus the broader market, with a bias toward higher coupon and shorter maturity bonds further down the credit quality spectrum. In our opinion, some of the more pro-cyclical sectors such as energy and leisure, which have benefitted from the re-opening of developed market economies amid higher vaccination rates, look well-positioned. In contrast, sectors such as retail are likely to face ongoing structural headwinds. 

When it comes to duration, our global high yield bond strategy is conservatively positioned from an interest rate sensitivity standpoint, with limited exposure to longer maturity bonds (>10 years). Consequently, the strategy remains less susceptible to rising U.S. Treasury bond yields.  

Another theme we are focused on over the next 12–24 months is around the increased potential for rising stars. These are companies that move from a high yield credit rating to an investment grade rating and, as a result, offer upside return potential. We have already seen an improvement in credit rating trends, with recent rating upgrade activity outpacing downgrades. Indeed, as we look ahead, one of the bright spots for the high yield market is likely to be around this increased rising star activity.

Ultimately, when it comes to uncovering relative value and deciding whether to invest in a particularly company, it is paramount to analyze the underlying credit fundamentals. In order to mitigate credit risk, we undertake in-depth fundamental credit analysis and also selectively invest in senior and secured parts of the capital structure. We also have one of the industry’s largest global teams, with 39 dedicated U.S. and European high yield credit research analysts. This size and breadth allows us to undertake detailed, bottom-up analysis of company financials and to actively engage with company management in order to identify attractive opportunities across a market that is over US$2 trillion in size.
 

How much exposure does the strategy have to the property sector?

Unlike the Asian credit markets, which tend to have a high concentration in the property sector—particularly from Chinese real estate companies—real estate is a much smaller issuer across the U.S. and European high yield bond markets, comprising less than 5% of the overall market.³ Given the relatively smaller investable opportunity set here, and given our view that there are more attractive risk-adjusted return opportunities available in different parts of the market, our strategy currently has a relatively small allocation to the property sector—and as a result can provide the potential for significant geographical and sector level diversification relative to an Asian credit offering.
 

How do you integrate ESG into the investment process?

ESG analysis is explicitly integrated into the bottom-up credit analysis that lies at the heart of our investment philosophy. Not only does ESG assessment have a direct impact on our internal credit grades, but it also factors into the team’s relative value decisions. 

Company engagement is an increasing area of focus for us. We launched our own proprietary system last year, which allows analysts to track engagement with portfolio companies and push for more disclosure. Our analysts actively engage with issuers and industry stakeholders in an effort to improve ESG-related disclosures and positively influence behaviors. As the global high yield market is characterized by a lower level of disclosure on sustainability metrics when compared to equities or investment grade markets, we believe that collaborative engagement is critical to improving disclosure and changing behavior—and continue to push companies for more disclosure around relevant information through frequent collaboration with other industry stakeholders, both in formal and informal settings. For instance, we are actively involved in the European Leveraged Finance Association (ELFA) ESG working group, which consists of buy side firms seeking an improved basic level of disclosure across loan and high yield issuers. Additionally, over the past 12 months, Barings’ broader fixed income platform has been involved in over 500 company level engagements.

We have also developed carbon reporting capabilities with our quantitative research team. When data isn’t available, we estimate carbon tonnage using comparable data. This allows us to track the carbon emissions of our high yield strategies versus the broader market, which improves company level engagement and feeds directly into our portfolio management decision-making process.
 

What are the main risks facing the high yield asset class?

There are several potential risks to be mindful of when investing in high yield. Given that these are investments in below investment grade-rated issuers, a key risk to highlight is credit risk, or the risk of default as a result of a borrower failing to pay back their debt obligations. At Barings, our team aims to manage credit risk by leveraging our large investment platform and undertaking rigorous due diligence on all underlying strategy holdings. Each credit in our portfolio is assigned an internal credit grade, outside of that from the ratings agencies, that is based upon our internal proprietary credit grading system. The credit grade is essentially a measure of the probability of default. 

Furthermore, we seek to build and manage a diversified portfolio in order to limit concentration risks across various aspects, such as single issuers and sectors. In addition to our investment teams, our strategies benefit from strong oversight from independent risk management functions.
 

Could you provide some detail about the investment process?

Our investment philosophy is predicated on the belief that long-term, risk-adjusted returns within the high yield asset class can best be achieved through strong fundamental, bottom-up credit research—with the goal of minimizing principal losses and identifying selective opportunities for capital appreciation during various periods over multiple credit cycles.

We take a credit-intensive approach when selecting assets. We seek to determine where favorable value exists within companies based on fundamental bottom-up analysis and assess this value on a relative basis to other investment alternatives. We focus on in-depth company and industry analysis, with particular attention paid to free cash flow generation capability, quality of management and capital structure. With 96 investment professionals across our broader high yield platform, we believe we have one of the deepest and most experienced high yield investment teams in the market, with a longstanding track record in below investment grade investing that dates back to 1999.
 

1. Source: ICE BofA Non-Financial Developed Markets High Yield Constrained Index. As of July 31, 2021.
2. According to Barings’ internal HY/IG Crossover tracker. 
3. Source: ICE BofA Non-Financial Developed Markets High Yield Constrained Index. As of July 31, 2021.