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Fixed Income

Sentiment Shift Fuels Lower-Rated Rally

2020 January - 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: Bank of America Merrill Lynch. As of December 31, 2019.

The document is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service.  The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This document is not, and must not be treated as, investment advice, investment recommendations, or investment research.

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In making an investment decision, prospective investors must rely on their own examination of the merits and risks involved and before making any investment decision, it is recommended that prospective investors seek independent investment, legal, tax, accounting or other professional advice as appropriate.

Unless otherwise mentioned, the views contained in this document are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice.  Parts of this document may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this document is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any forecasts in this document are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Any investment results, portfolio compositions and/or examples set forth in this document are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments.  The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this document.  No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments.

Investment involves risks. Past performance is not a guide to future performance. Investors should not only base on this document alone to make investment decision. 

This document is issued by Baring Asset Management (Asia) Limited.  It has not been reviewed by the Securities and Futures Commission of Hong Kong.

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