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

The economic recovery has morphed into a meaningful period of expansion. Growth expectations remain favorable. The U.S. consumers’ financial position has improved as asset values have risen. Consumer spending comprises over 70% of GDP, and household balance sheets look strong. The recovered value of assets combined with limited debt accumulation means that household net worth has topped pre-recession highs by a sizeable margin. Household debt service ratios stand near 35-year lows, indicating a dramatic deleveraging among U.S. consumers. Despite the expected downshift in growth, American companies should continue to grow profits, and the U.S. still represents an attractive investment opportunity. A continued sub-trend growth and low inflation is a bond-friendly environment.

Global Fixed Income

Risk in fixed income markets may actually be greater now compared with the period prior to the “taper tantrum” in the spring of 2013, despite current widespread complacency about rates heading higher. Among the key considerations in navigating today’s fixed income markets:

  • With yields at historic lows, it is difficult to generate even a 3% yield without putting principal at risk. According to Fitch Ratings research, the aggregate total of government bonds that carried negative yields at the end of April was approximately $10 trillion, with Japan accounting for roughly two-thirds of that, and Europe the remainder. While rates are likely to stay low, even with further Federal Reserve rate increases, this radically changed landscape presents a huge obstacle to investors.
  • The average duration in the fixed income market continues to expand. Duration has extended dramatically in every developed sovereign market in recent years. This suggests that investors have to take on greater risk for the diminished reward potential.

Because risk in fixed income markets may actually be greater now, despite widespread complacency about rates going higher, fixed income investment success in the years ahead will require maintaining both flexible and highly diversified portfolios that can avoid the pitfalls of persistently low, and in some cases, negative interest rates. Nimble strategies can take advantage of developments in high yield.

Global High Yield Bonds

Among bonds’ appealing features is the steady current income they provide to investors. But today, yield has become harder to find amid highly accommodative monetary policy by the world’s major central banks. In a world of low absolute interest rates, an allocation to global high yield portfolios is an attractive option for investors who are willing to accept greater credit risk and potential volatility in exchange for larger coupons and shorter durations.

A truly global approach to high yield corporate bond investing can enhance return opportunity. With a broader array of securities to select from, global high yield portfolios can take advantage of unsynchronized credit cycles, relative value disparities, and differing return potential across regions. There is also meaningful potential to profit from market dislocations and volatility triggered by disruptive macroeconomic and geopolitical developments. Five years ended May 31, 2016, the BofA Merrill Lynch Global High Yield Index, the primary benchmark for global high yield outperformed the more traditional J.P. Morgan Global High Yield Index with comparable levels of volatility. Investors can seek to optimize interest-rate risk by region and economy by decreasing allocation to interest-rate-sensitive bonds in regions where rates are normalizing faster, and by increasing interest-rate-sensitive allocation in regions where monetary policy is staying easy or getting easier.

Global high yield portfolios may be volatile at times due to exposures to countries with less developed political and economic systems. Market liquidity can be particularly challenging in emerging market countries, and investors should be willing to endure bouts of turbulence when risk appetite fades. However, volatility and economic uncertainty create some of the most exciting investment opportunities, and the power of compound interest will reward risk-tolerant global high yield investors over time. Investors should bear in mind that credit selectivity is a key driver of performance. Global high yield investing requires an active management approach that employs specialized, globally based research resources to properly assess credit quality and value across the corporate capital structure.

European High Yield Bonds and Emerging Markets Corporate Bonds

European high yield bonds and emerging markets corporate bonds markets are less mature and less followed than U.S. high yield bonds, so they offer more opportunities to exploit security mispricing and market inefficiencies. Yields may seem low, but spreads on a credit-by-credit basis are comparable to those in the U.S. and poised to tighten as investors continue their search for yield. The growth in Europe is also supportive of improving fundamentals and potential upgrades.

A challenge for creditors is that approximately 30% of new European high yield offerings are from first-time issuers. Many of these companies are not publicly listed, as European firms have traditionally relied more on banks than on capital markets for financing.

A key decision is how to allocate among U.S. high yield bonds, European high yield bonds, and emerging markets corporate bonds. As these markets have grown and matured, performance dispersion has increased due to the unique economic and political forces at work around the world. Investors can take advantage of this through dynamic geographic allocation decisions. Individual country and security performance has varied widely given the challenges faced by some commodity exporters and other idiosyncratic factors, demonstrating the need for selectivity. Another important consideration is credit quality allocation, as there are structural differences between regions, and certain ratings segments offer better risk-adjusted return potential. U.S. high yield bonds have longer track record and clearer legal codes.

 

 

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