Capital Ideas^TM

It has been a challenging year for fixed income markets in 2022 amid rising inflation and slowing global growth.

While uncertainty is likely to remain elevated, today’s starting yields offer an attractive entry point for long-term investors. Yields across sectors are sharply higher compared with lows over the recent past.  At current levels, history suggests higher total returns over the next few years.

This higher income can offer more of a cushion for total returns over time, even if price movements remain volatile. In fact, a greater portion of investors’ income needs could potentially be met with traditional fixed income than would have been the case in recent years. 

The broad credit universe provides ample opportunities for investors to add value through bottom-up research and security selection in each of the four primary credit sectors — high yield, investment grade, emerging market and securitised debt. Keeping a long-term view and employing balance can help smooth the way.

1. High yield is finally high yielding

With yields at 9.7%, the US high yield market is looking attractive again and could present a compelling opportunity to add to positions, should fundamentals continue to outperform expectations of slowing economic growth. With fundamentals in good shape, the asset class is healthier and more stable than it has been in many years. It is a larger and more diverse market, and the overall credit quality is higher than it has been during other periods of slowing growth. BB-rated credits make up over 50% of the market.  (See charts on page following).

That said, we are cautious as high yield spread widening year-to-date has been limited relative to spreads in higher quality sectors. As such, a repricing of risk based upon negative changes in the economy could have an outsized impact on the sector. Should the US economy enter a recession, we would expect high yield to underperform investment grade and securitised sectors, thus we have recently reduced exposure. That said, there are many positive attributes of the sector which contribute to our current sizing of the sector.

The absence of near-term large-scale refinancing requirements is also supportive. Corporates tapped into the low-rate, favourable credit environment of the past few years, meaning that many do not need to issue at prevailing higher rates. The volume of issuance could therefore remain low for at least another year.

In terms of defaults, at 1.6%¹, the latest 12 months’ default rate is low by historical standards. Looking forward, an early indicator of future defaults is distressed debt. Today, distressed debt as a percentage of the high-yield universe is in the mid-single digits. Based on this metric, while we do think the default rate will likely rise from low levels, we do not expect it to spike.

Another factor that we consider is debt that is rated triple-C or below. This too, is around historical lows at about 13% of the high-yield market, compared to 20% in December 2007.²

The combination of these three parameters presents a constructive view of the sector, which supports our current position.

Meanwhile, average duration of the US high-yield market is lower than that of US investment-grade credit.³ A lower sensitivity to higher interest rates is attractive at a time when central banks are trying to tame inflation.

The high yield sector is instrumental to a multi-sector credit strategy as over time it typically generates the highest level of income, which is the key contributor to total return over a full market cycle. The size and diversity of the sector allows for ample opportunity to add value through fundamental research and appropriate risk allocation across quality and industry.

1. As at 30 September 2022. Trailing 12-month results. Source: JPMorgan

2. As at 30 September. Index used is the Bloomberg US High Yield Corporates 2% Issuer Cap Index. Source: Bloomberg

3. As at 30 September 2022, as measured by the modified duration for the Bloomberg US High Yield Corporates 2% Issuer Cap Index and Bloomberg US Corporate Index. Source: Bloomberg

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.