Macro Themes and the Implications: Time to Pay Attention to Global High Yield Strategy (I)

Key Macro Themes and the Implications

Low inflation: Inflation is low but it does not mean inflation is zero. The slow growth in global economy keeps inflation subdued even as CPI slowly rises.

Global policy divergence: Fed continues to normalize slowly as other central banks pursue stimulus policies. Investors should expect yields to rise modestly.

Supply-side weakness: Across developed countries, the low productivity and growth in labor force will ultimately cap longer-dated yields.

Strength in U.S. economy: U.S. economy remains resilient; recession risks are being overpriced for 2016, which indicates a good environment for high yield bond.

Gradual recovery in Europe: The expansion in Europe is on track; monetary policy is a key factor that will support EU stocks and credit markets.

Japan – beyond Abenomics: The economic risk in Japan is becoming more binary; the asset returns will be more geared to fiscal response.

Emerging markets rebalancing: The stats of emerging markets implies that the environement is stabilizing and the valuations are undemanding. The short-term risks exist but investors can expect the conditions will improve in 2016.

China in transition: That China is shifting from resources to services will continue to weigh on global trade.

U.S. High Yield Bonds

In an environment of full valuation, fragile investor sentiment, favorable relative valuations of credit over equity, slow but positive growth with limited recession risk that is priced in, high yield credit that offers equity-like returns is an attractive proxy for stocks. U.S. High yield credit spreads widened the most since 2011.

U.S. high yield bonds offer lower volatility than equities due to their coupon income. In down markets, a larger coupon for high yield bonds helps to offset market declines; in up markets, high yield bonds usually correlate to rising equities. Moreover, high yield bonds are generally not impacted by modest rise in interest rates; spreads are more a reflection of market expectations for future default rates rather than expectations for higher interest rates. Furthermore, high yield bonds managers charge lower fees as compared to the hedge funds specializing in distressed debt.

Despite U.S. high yield bonds offer equity-like return, investors need to adjust or discount the asset class for its potential for downside losses, liquidity constraints, sector risks and other realities:

• The high yield bonds market is characterized by asymmetric risk whereby the potential for downside losses outweighs upside capital appreciation. Asymmetric risk exposure is a situation in which the potential gains and losses on an investment are uneven.
• The high yield bonds are traded over the counter, which highly depends on dealer capital. Additionally, the majority of high yield bonds do not trade on a daily basis, which means there may be a significant difference between trade prices and broker quotes.
• Independent fundamental analysis is paramount. The market generally anticipates upgrades and downgrades long before the actual rating changes.
• The difficulty in estimating defaults is defaults are not correlated to the severity of recessions. For instance, the 2008-2009 period was not the worst for defaults but it was dramatic to other asset classes.

The key to long-term success in investing in high yield bonds is managing credit risk, avoiding dangerous concentrations and minimizing defaults in the portfolio. In addition, in harvesting carry across extended credit markets, security selectivity becomes even more crucial. Investors shall stay engaged, know the securities; do not be afraid of sentiment.

The increase in volatility is creating numerous opportunities for fundamental, bottom-up investors. With more movement in the market, there is a wider range of possible outcomes, some of them lost, but some of them gained. While the downside increases, so does the upside. As with any investment, the riskier it is, the greater the possible return is. Furthermore, a contrarian stance, backed by a comprehensive understanding of companies’ long-term fundamental prospects, will provide a strong foundation to withstand as well as profit from a world of rising volatility.