341. Why high yield isn’t as risky as you think

14 November 2024 (pre-recorded 12 November 2024)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This episode takes a look at the world of high yield bonds, examining current trends, risks and opportunities — including, why high yield isn’t as risky as commonly perceived.

Joss Murphy (JM): I’m Joss Murphy, research analyst at FundCalibre, today I’ve been joined by Jack Holmes, manager of the Artemis Global High Yield Bond fund. Hi Jack. How are you?

Jack Holmes (JH): Hi there, Joss good. How are you?

[INTERVIEW]

JM: Very, very well, thanks. Very well, thanks. First let’s just start with a brief introduction into what high yield is and how we sit today.

JH: Yeah, perfect. Well, look, the high yield market is a part of the bond market. So it’s about lending to, specifically to companies in this case, and the name High Yield basically alludes to the fact that we are lending to slightly riskier companies and therefore getting paid more for that.

Now it is a market which has historically had a varied reputation. A lot of people kind of consider them junk bonds and worry about, you know, defaults and excesses within the market. I think that’s somewhat overplayed. If we look at the market today, it’s a very different market to the market it was in the 90s or 2000s.

So for instance, more than half of the market today is BB rated, which is the highest quality part of the high yield market just below investment grade. And if we look at that through time over the last 50 years, the average default rate on that part of the market has actually been 0.6%, so a very low default rate. So I think what’s is it a Hardy quote, the rumours of my demise are exaggerated. [This quote is actually attributed to Mark Twain.] I think the rumours of risk within high yield are actually exaggerated.

So whenever I look at the market today, you know, more than 50% BB, less than 10% CCC, the riskiest part of the market, which is actually where we see the vast bulk of defaults occurring through history. It actually looks it looks very attractive with currently, you know, if I’m talking about for a sterling investor in our fund a yield of almost 7.5%, that looks like an attractive place to be relative to, again, a relatively low default risk going forward.

JM: And then Jack, in that case what area of the market are you currently favouring?

JH: Yeah, so we run a global strategy so we can theoretically invest anywhere in the world. In reality high yield is broadly segmented into US, kind of North American high yield, European high yield, which includes the UK and then emerging market high yield. We focus in our strategy on developed market high yield because we think it actually offers the best risk reward for us and the best expression of our particular strategy. But within that, at the moment we are focusing more on on European and UK credits and bonds. We actually find that that market relative to the US looks a lot more attractive in terms of pricing versus the risk that we’re taking. So we are currently more focused on Europe.

The other area that that’s worth highlighting is, again, going back to that point about different credit ratings and the level of risk we’re taking through those. We’re focusing very much on the BB and B part of the market, the higher quality parts of the high yield market, and avoiding CCCs at the moment, the lowest quality, highest risk part of the market.

Just to put some context on those, kind of the different risks between those two areas, over the last 50 years, if we look at those default numbers, I mentioned the 0.6% annual default chance in BBs, that figure is 26% in CCC. So you’re taking 50 times more risk within the CCC part of the market than you are within the BB market. And frankly we don’t see that reflected in pricing today. So we’re focusing on higher quality, high yield, lower chance of default.

And the final thing I should mention is we are focusing very much at the moment, given the current yield environment on shorter dated bonds. So bonds maturing in less than say six years. We think that is a much more attractive part of the market where we’re actually able to get some very, very high yields, but without having to take a big bet on actually the direction of yields going forward.

And I think that’s been certainly the lesson of the last couple of years has been actually taking a, if you like, a a pound of yield upfront is actually a very valuable thing to do versus trying to make a bet on what it’s going to look like in 20 or 30 years time. So, so yeah, so broadly BB, B, higher quality within the market, more focused on Europe than we are on on North America. We’re not investing in emerging market high yield. And within the maturity profile, very much focused on the front end in terms of shorter maturity bonds.

JM: And Jack, you said that, that there’s 50 times more risk in the CCC and that isn’t quite reflected in current prices. Does does that mean that the high yield market is inefficient or can you elaborate on this for me?

JH: Yeah, sure. I mean, yes, the high yield market is inefficient. I’m an active manager, the fund that I run is a very active strategy. We’re looking to invest in between 80 to 100 bonds versus 1,600 issuers in the universe of about 3,000 bonds. So we’re very much looking for a way of expressing an active view within this market. So by implication, we have to think that the market is inefficient. Certainly our performance over time would suggest that there’s inefficiencies that we can benefit from.

I would say the rating part of the spectrum is definitely one of the areas where the market is inefficient. Generally, in good times, CCCs are to our mind overvalued and in very weak periods of market return, they actually tend to be undervalued. You know, people actually have a kind of fire sale approach to the CCC part of the market. So at the moment, spreads are reasonably tight in terms of the credit spread between government bonds, kind of risk-free rates and what we get paid for lending to a company. So we are focusing on the higher quality part of the market because frankly, we don’t think we’re getting the compensation for reaching into the CCC part of the market.

I guess the other point I should mention is we are a global strategy. Now there are other global strategies in the high yield market, but I think we are reasonably unique in actually looking at things from what we would consider a kind of truly global perspective in that each of us who work on the fund actually look at bonds from across the spectrum. So, US dollar bonds, European bonds, sterling bonds, we look at across the whole gamut of currencies, the majority of high yield investors will focus on a single currency, and that can create some very big pricing discrepancies between even bonds of exactly the same company, exactly the same fundamental risk. You can actually create a lot of value by just looking between those different currencies and picking the most attractive opportunity within that.

The final point is really around the dynamic in the market. High yield is a market which is unlike equities where you kind of have this framework around large cap, mid-cap and small-cap, depending on which part of the market you want to look at and which size of company you want to look at. That doesn’t really exist in high yield. High yield is just the high yield market. There’s no real distinction by that framework. What that does is it actually means that there’s a massive amount of analytical attention and capital that goes towards those larger issuers, those larger companies in the high yield index, which we think results in them actually being, to be honest, structurally overpriced versus a lot of those smaller issues.

And I should emphasise here, when I say large and small issuers, I’m not necessarily talking about large and small companies. A lot of those smaller issuers are companies with market caps in the tens of billions earnings in the billions, but they just don’t use the high yield market as a significant part of their funding structure. Actually, if we look at a lot of those larger issuers, frankly, the reason they’re large issuers is because they’ve been burning so much cash through the last five or 10 years that they’ve had to borrow lots of money. To be honest, they’re exactly the kind of companies you don’t want to lend to within the market.

However, the way that the market is structured in terms of people just generally looking at the high yield market as a whole, it means that capital and analysis tends to flow towards those larger issues because they’re the bigger parts of the benchmark that people focus on. So by focusing on the smaller issuers, we think we have a structurally more attractive in terms of yields available, but also a less efficient market for us to find individual opportunities within. And I would say that’s been one of the kind of five plus years that we’ve been running this strategy it’s been one of the most profitable areas in terms of finding opportunities within that part of the market versus the larger issuers, which frankly everybody owns and everybody knows very well.

JM: Well, that’s all very interesting and it’s a strategy that certainly makes sense. Jack, unlike with investment grade debt, high yield bonds can be called or redeemed before they mature. Can you explain this for us and give an example of what this means for the bond holder – or the fund, in this instance?

JH: Yeah, I mean, it’s been one of the really interesting things over the last two years actually, and it’s something that we’ve been quite aggressive in terms of exploiting. High yield bonds are very different from investment grade bonds and from government bonds, as you say, because they can be redeemed or called early by the company. So rather than simply waiting for a maturity date the bonds can basically be paid up in full by the company before that point.

Now you may say, well, what difference does that make really? Well, what’s interesting today is the majority of the market is trading below par, below 100. In effect, if you think about a bond as pricing with say a £100 of capital behind it, the bonds are trading below a £100 in terms of the price that you would pay for that bond.

What that means for a high yield company is actually because these bonds get redeemed early, and if we look over the last 12 months, on average, bonds are being redeemed about a year and a half ahead of maturity. What that means is, effectively if we buy a bond that say on paper maturing in three years time at a price of say, 90p on the £1, what actually happens is in say, a year and a half’s time, if that company comes and redeems that bond early, redeems that bond at a price of 100 or above, then effectively we get a a kind of early capital upside in that position.

So by focusing on this part of the market and by looking for these opportunities where the market is just mispricing the chances of companies coming back and refinancing these bonds early, it actually has created quite a lot of value for us where we’ve had a very strong period for the last two years in terms of delivering positive total returns, both in absolute terms and versus the market, but we think we’ve actually done it with a lot less risk by focusing on higher quality bonds within the shorter data part of the market.

It’s just a fundamentally much less volatile part of the market, but also we’re able to extract that capital upside from these early calls happening. So we’ve kind of had the best of both worlds really in this kind of strategy going forward that looks like it will continue, but it is really a function of the fact that a lot of these bonds were issued before yields across all fixed income markets significantly rose in 2022. So there is a natural kind of process by which those bonds will no longer exist and therefore will have to adapt our process to find different sources of alpha. But for the next year, two years, we think this is gonna be a very strong contributor to performance going forward, as it has been over the last two years.

JM: And maybe kind of looking more broadly, most major economies have started that rate cutting cycle. What does this mean for high yield?

JH: Yeah, I mean, in general it should be a good thing. We should be seeing interest rates coming down, which should stimulate economic activity, which broadly should be positive for high yield. High yield companies tend to be more related to the cycle than a lot of other a lot of other parts of the bond market. The other thing is that because high yield is naturally a shorter dated market than other parts of the bond market, so whereas say the average maturity in our fund is about three and a half years, the average maturity in say an investment grade or a government bond fund may be 7, 8, 9 years. So it’s a shorter maturity part of the market overall, and that is the area which is being most impacted by that those interest rate cuts and effectively that should create capital upside for an investor in those shorter dated bonds.

So overall it is positive.

I think the other way of looking at it though is if we think about this year, it’s been a really I think a lot of people came into this year thinking this is a year where central banks are going to start cutting rates, therefore bonds of all stripes are going to do very, very well, because yields are going to fall, there’s going to be a lot of capital upside for investors. And I think what’s been interesting is it has been a good year for certain parts of the bond market.

So for instance, our strategy has delivered a return of almost 11%, a very strong return for investors. But if you think about it, the most obvious place if you thought, okay, say the Federal Reserve in the US are gonna start cutting interest rates, what’s the most obvious way that I can make money out of that? I’ll go and buy US treasuries. So US treasury, so US government bonds, the ones that are most correlated to the Federal Reserve cutting cycle the US Treasury, ETF, so the ETF that’s reflecting that part of the market has delivered a return of 1.4% year to date. So less than half of what you would’ve got from just putting that money in a savings account. So it isn’t that it’s been a bad year for bonds. Certain parts of the market have done very well, like high yield but actually the obvious elements that you could have looked at and said, well, okay, we are going into a cutting cycle, therefore government bonds are going to do very well. Actually, it hasn’t played out that way.

so I think it has kind of highlighted that actually we are in a different cycle this time round. And actually sometimes going back to that point I was making earlier about having the pound of yield upfront rather than making a bet on what happens in terms of what’s called longer duration assets, you know, assets that have longer maturities and are more sensitive to interest rates moving up or down. Actually it’s been a better environment to focus on, if you like the burden the hand rather than the two in the bush.

JM: And then maybe going forward to next year, is your view an optimistic one? What’s your outlook on the high yield sector?

JH: I mean, overall, I’m optimistic. I think it’s a good market for high yield. I think we are starting with, I think I mentioned it earlier, but a yield on the fund of almost7.5% for a sterling investor, that to me looks like a very attractive level of return, especially considering the fact that, as I mentioned, both in terms of the market and in terms of our positioning within the market, we are relatively conservatively positioned. So I’m pretty positive in terms of total returns for investors.

If you look at history, the best guide to what returns look like has been the starting yield on average. That’s the outcome that people receive. So kind of high single digit returns for an asset class that exhibits a fraction of the volatility of equity markets say, looks like a pretty good deal for me.

I think it is important though to really emphasise the difference between a passive and an active approach, though. If I look at the market today, it’s a market which has some unusual characteristics to it. So normally if I was worried about the market or I was trying to position conservatively within the market, I would sell cyclical companies and I would buy non-cyclical companies. So I’d sell, you know, construction firms, I’d sell industrial production companies, things like that, and I’d buy maybe telecommunications or healthcare bonds instead. I think this is actually a very, very different environment because I think the risks actually within high yield are more focused on the non-cyclical part of the market because we have to remember, there’s two parts of the equation. There’s the volatility of the underlying business, but then there’s also the capital structure that’s being applied to it.

And what we’ve seen over the last decade has been a lot of those non-cyclical businesses, because they were seen as such a safe haven, have actually had huge amounts of debt put on them, given by high yield investors. And a lot of those larger issuers I was referring to earlier, that we are avoiding are actually in those sectors, telecommunications, healthcare, where they’ve been able to, to borrow huge amounts of money because frankly, investors looked at them as very, very low risk. I don’t have to worry about people not paying their medical bills or paying their phone bills, and that’s fine, but what we’re actually seeing is a lot of those business models are actually being structurally challenged.

You know, if I look at things like cable TV, cable TV frankly does not have the same ability to charge customers what it does what it did 10 years ago, given we now have Netflix and Amazon Prime and all of those other over the top services. So there’s a change in the business model of a lot of these, but also, frankly, these are the big balance sheets where that change in yield environment that we saw from 2022 onwards means that the cost of funding those balance sheets, those big balance sheets has more than doubled for a lot of these companies. And frankly, they’re, they’re not built to sustain those levels of of interest cost.

So I think we’re in a very interesting dynamic today where actually those non-cyclical actually look like the most risky part of the market. On the other side, if you are a cyclical business within high yield, and you’ve been around for the last five years, which the majority have, we haven’t really had a lot of new issuance in high yield. So it’s basically the same cohort of companies we were looking at five years ago.

If you’re a cyclical business, you’ve survived Covid where probably your revenues basically went to zero for three to six months, you then survive the inflation spike in the supply chain issues of 2021 and 2022. And then from 2022 onwards, you’ve basically had your interest cost double or triple. If you are sitting here today, and you look reasonably well positioned with a reasonably resilient balance sheet today, I would argue for a cyclical business, you’ve had basically all the stresses you could have put upon you over the last few years. And that to me makes me quite bullish because a lot of people are still regarding those businesses as very, very risky businesses. And therefore they’re expecting very high yields to lend to them. I think that looks like a much more attractive place to earn your yield in high yield rather than frankly lending to a non-cyclical business that while on paper it may look like a good risk reward is actually carrying a lot more structural problems with it than perhaps investors are appreciating.

JM: Jack, thank you very much for your time today.

JH: Thank you very much.

SW: This is a high-conviction fixed income portfolio of high yield issuers across the globe. The managers look to increase the value of shareholder investments through a combination of both income and capital growth.We like the unique approach behind this fund, with the managers taking advantage of the inefficiencies created by many of their peers focusing heavily on the larger players in the index. To learn more about the Artemis Global High Yield Bond fund please visit fundcalibre.com