Capital Ideas^TM

It is no secret that 2022 has been challenging for fixed income investors. High inflation and the US Federal Reserve (Fed)’s initiation of interest rate hikes have weighed on markets. Nevertheless, 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 markets and securitised debt.

In this article, we discuss how income-seeking portfolios can be structured with the aim of adding incremental alpha (excess return) through security selection and asset allocation within a prudent risk management framework.

Among these four credit sectors, capitalising on relative value can be a very powerful way to enhance returns, especially during periods of high volatility like the one we are experiencing now.

Here are our current views on each sector within credit and where members of our investment team are finding what they believe are attractive return opportunities within the construct of a multi-sector income portfolio.

1. High yield has not seen prolonged periods of negative returns

The high-yield corporate bond market has a long-term record of producing a high level of income, which is the primary contributor to its total return over a full market cycle. The sector is large, at about US$1.5 trillion, and spans a multitude of industries and issuers. Investors comfortable with taking on the higher risk associated with high-yield bonds can also choose from a range of bonds of varying quality (secured and unsecured across the BB to CCC ratings spectrum). The high-yield universe also provides significantly shorter duration than investment grade (IG) corporates and emerging markets debt (EMD).

Unlike equities, where valuations reflect expected future cash flows, high-yield returns are much more a function of an issuer’s current cash flows and ability to service debt. While high-yield spreads can be volatile and directionally correlated with equities, the yield serves to cushion drawdowns and drive attractive total returns over multi-year periods. Spreads refer to the difference in yield between two bonds or types of bonds, which investors use to gauge the valuation of a bond. In fact, it has been quite rare for the high-yield sector to experience prolonged periods of negative total returns.

A large part of the sector is reasonably liquid, allowing for fundamental research to guide relative value decisions by moving between securities from different parts of a company’s capital structure, within an industry or across the high-yield sector. That said, we have recently reduced our allocation to high yield, to well below our neutral allocation, as we believe its relative value has declined compared to emerging markets, securitised credit and investment grade.

Over multiple decades, the relationship between high-yield and investment grade spreads has followed a similar pattern. High-yield spreads tend to widen significantly compared to investment grade during crises and periods of weak economic growth. Historical spread relationships act as a guide for when high yield becomes more attractive than investment grade during periods of stress. Outside of those crisis and recession periods, spread relationships are much more stable and generally hover within a predictable range. In the current environment, we expect that slowing economic growth will continue to push high-yield spreads wider compared to investment grade. As such, we are monitoring valuations and the economic backdrop and will increase our holdings given the right windows of opportunity.