There is a lot to unpack in this question. The short answer is, pretty good.
The major stock indices are, as I say, still reeling, with the strong-growing Eurostoxx and Nasdaq both down 15% year-to-date. The global high yield market is down nearly 6.3% year-to-date in sterling terms. Digging deeper, the US market is down 4.8%, while European high yield is down 5.8%. Given the proximity of the conflict and Europe’s dependence on Russian raw materials, this difference is not surprising.
Indeed, the US high yield market remains far more concerned about rising interest rates and duration risk than overall demand in the economy and the potential for increased defaults. An illustration of this point is the continued outperformance of low-quality CCC bonds. High yield market commentators have argued for months, if not years, that CCC bonds are a good place to hide from rising interest rates. The high coupons on offer are naturally more resilient to rising interest rates than the lower coupons you typically get from, for example, BB-rated bonds.
Of course, with commodity prices exploding, the large cohort of commodity sector bonds in the CCC-rated US portion of the market are benefiting. With fixed and limited bond upside, especially when the market has already largely priced in their current good fortune, we don’t think this is a theme that bond investors should embrace too easily. We should always keep in mind the default bias towards the lower quality segments of the market, illustrated in Chart 1 below. If an investor wants to bet on thematic and cyclical companies, it is best to do so in the stock market.
There is no such outperformance of CCCs in Europe, where the specter of stagflation is arguably greater. Stagflation is when you have both inflation and a declining economy. Inflation was already proving desperately persistent before the commodity price boom and will, of course, be exacerbated if commodity prices remain high. Meanwhile, European manufacturing and discretionary consumer spending will likely both be hit. The inflation part of this problem means that central bankers will be reluctant to reduce monetary policy as they normally do in a downturn.
To a large extent, these fears carry over to European high yield spreads, the risk premium we are paid for the risk of default that accompanies high yield bonds. The European high yield spread – as shown in Chart 2 – has now risen to 4.8%, well above the long-term average of 4.1%, and we see this as an attractive risk offset. .
Note that US high yield spreads are still below the long-term average, but with the number of interest rate hikes embedded in US government bonds, the overall return is in line with the long-term average. Therefore, we also like the US high yield, especially considering the likely resilience of the US in the face of a continued escalation in Ukraine. In our view, there is much less risk of a default spike in the US.
Our high yield exposure is currently split evenly between the US and Europe (including the UK). We have low exposure to cyclical stocks and companies with high energy production costs. We don’t have any airlines, which are so exposed to fuel costs. The quality bias we have in our process means that we are very light on CCC risk and have no noticeable risk in emerging markets. Additionally, our quality bias means we also look for companies with pricing power and resilience, two operational qualities that are the best defense in tougher economic times. With these features, our high yield holdings have an average gross redemption yield of approximately 6.7%.
Some may counter that if you’re optimistic about defaults, as we are, why not own more CCC and increase your yield? The main reason we are generally optimistic about defaults is that a small proportion of global high yield debt is due in the short term: 7% in 2022 and 16% in 2022 and 2023 combined, as shown in the Chart 3. Although, if you’re old enough, you’ll remember that the high yield market closed to new issues for 18 months during the global financial crisis! To be clear, we don’t believe this event will cause such a level of tension in the market. Looking at Chart 1, we still believe that a quality bias is the best way to approach the high yield market over the long term.
Many customers ask about liquidity. The honest answer is that in times like this, liquidity is more difficult when trying to access an offer. Often the selling price is lower than what is shown on our Bloomberg screens (and therefore factored into market prices). We often see more liquid large corporate bonds indicating greater volatility than parts of the market with, in our view, higher risk of default.
During longer periods of market stress, this price dynamic tends to play out and the lower quality and less liquid segments of the market catch up in terms of market price. Our “big, liquid, listed” mantra means that we expect to be less affected than many during such times.
The corollary is that longer periods of market stress create opportunities for valuation, as the compensation for future defaults – the spread – often overreacts. We don’t think this time is any different.
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Main risks
Past performance is no guarantee of future performance. The value of an investment and the income from it can go down as well as up and is not guaranteed. You may get back less than you originally invested. The issue of units/shares of Liontrust Funds may be subject to entry charges, which will have an impact on the realizable value of the investment, particularly in the short term. Investments should always be considered long term. Investments in funds managed by the Global Fixed Income team involve foreign currencies and may be subject to fluctuations in value due to fluctuations in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the interest rate. Bond markets may be subject to reduced liquidity. The Sub-Funds may invest in emerging markets/weak currencies which may have the effect of increasing volatility. Certain Funds may invest in derivatives. The use of derivatives may create leverage or leverage. A relatively small movement in the value of the underlying investment of a derivative instrument may have a greater impact, positive or negative, on the value of a fund than if the underlying investment were held instead. .
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Friday, March 11, 2022, 1:19 PM
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