Public Fixed Income

Sentiment Shift Fuels Lower-Rated Rally

January 2020 – 3 min read
Uncovering relative value across high yield in 2020 may require looking in less obvious places.

The positive streak continues for global high yield. Risk assets are back in favor, which combined with improving sentiment and the continued search for yield has contributed to strong performance across the markets. U.S. and European high yield bonds have led the way, registering the strongest performance in recent years (13.98% and 10.74%, respectively).1 U.S. loans (8.17%) and European loans (4.38%) also ended the year in decidedly positive territory.2 In the context of a relatively healthy fundamental backdrop and low default outlook, the asset class looks to be on solid footing overall. 

With this renewed “risk-on” mentality, the bifurcation that characterized much of the last year has started to reverse. While spreads on BB assets have tightened, spreads in the lower-rated parts of the market are still relatively wide. This, combined with decent economic conditions, stable fundamentals and higher-than-expected earnings contributed to a fourth-quarter rally in select, lower-rated CCC assets that has extended into 2020. While this trend has been more pronounced in Europe—a market with less exposure to energy—it has also materialized in the U.S., where CCC bonds (5.3%) significantly outperformed BBs (1.3%) and single-Bs (2.1%) in the fourth quarter.3

All of this said, risks continue to punctuate the investment landscape—tensions in the Middle East are escalating, Brexit turbulence continues, and the U.S. faces what is sure to be a politically charged year in the run-up to November’s presidential election. Not to mention the persistent concerns around commodity prices, trade, monetary policy and economic growth. 

We can’t say with any certainty how these factors may impact high yield going forward. What we can say, based on history, is that financial markets typically don’t price risk very well. They also have a history of overreacting to headlines and a tendency to exhibit short-term pricing inefficiency during periods of dislocation or volatility. But these periods can—and often do—lead to opportunities.

We’ve seen this in the loan market in particular. Increasingly dovish Fed policy contributed to material outflows from loan retail funds through much of last year. As the yield differential between bonds and loans shifted in favor of loans, an attractive—and somewhat contrarian—opportunity emerged. While the outflows have reversed in recent weeks, loans continue to offer attractive yields relative to bonds, in our view, particularly given their higher historical recovery rates—a result of being senior in the capital structure and secured by some or all of a borrower’s assets. 

Yield Comparison
(3-Year Discount Yield for Loans, Yield-to-Worst for Bonds)

Sources: Credit Suisse, ICE BAML. As of December 31, 2019.

Pricing discrepancies also exist at the sector level, and may emerge as an additional source of opportunity over the coming months. Health care, for example, is one sector that will almost certainly experience election-induced turbulence in the months ahead. But health care is a vast industry, comprising many different types of companies that produce widely different products and services. As the market reacts to headlines over the coming year, buying opportunities may very well emerge in good credits that have essentially been weighed down by headline risk. 

Outside of traditional high yield bonds and loans, some of the most interesting opportunities we see today are in areas like collateralized loan obligations (CLOs), distressed debt and emerging markets debt. In this continued slow growth, low-rate environment, investors can potentially earn incremental yield by intentionally expanding their opportunity set in a strategic way in these less traditional asset classes. 

Now is not the time to ‘buy the market’ when it comes to high yield. It’s a time to be thoughtful, deliberate and nimble. Markets are reactionary, and will move in response to risks and headlines—often in a different direction than what fundamentals would suggest. When they do, those with the ability to move quickly and efficiently will be best positioned to potentially capitalize on the resulting opportunities.

1 Source: Bank of America Merrill Lynch. As of December 31, 2019.
2 Source: Credit Suisse. As of December 31, 2019.
3 Source: BAML. As of December 31, 2019.

Martin Horne

Head of Global Public Fixed Income

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