High yield markets have historically offered investors the chance to earn attractive returns, but given the below investment grade nature of the asset class, a certain amount of volatility must be expected. Today is no different; with index-level yields in the mid-single-digits, it’s no wonder that investors continue to allocate to high yield markets, especially in light of the negative yields on offer across much of the world’s sovereign bond universe. However, as the credit cycle has matured, simply making an allocation to credit and high yield may no longer be enough – a more nuanced approach may be needed.
Specifically, here are three tactics that investors may want to examine when allocating to below investment grade credit:
1. Consider a global high yield multi-credit approach
Global high yield multi-credit strategies invest across the full spectrum of below investment grade markets in both the U.S. and European markets. These strategies can invest not only in high yield bonds but also in senior secured loans and 2nd lien loans; some of these strategies also offer opportunistic allocations to stressed credits and/or collateralized loan obligations.
The flexibility inherent in global multi-credit strategies allows managers to scour the high yield universe for attractive market and relative value opportunities. History has shown us that relative value can change quickly – between geographies – and also between sub asset classes like loans and bonds (Figure 1). Such changes are often driven by technical factors like fund flows and require a certain level of expediency and market familiarity to exploit.
If executed well, multi-credit strategies offer the potential for higher risk-adjusted returns than may be achievable in the underlying asset classes themselves.
Figure 1: Global Relative Value: Across Sub-Credit Asset Classes and Regions
2. Seek seniority in the capital structure
While the default environment in high yield markets – especially outside of the energy and commodities sectors – has remained relatively benign, investors may be wise to carefully consider where in the capital structure they are investing. Many investors already recognize the benefits inherent in senior secured loans, which sit at the top of the capital structure, meaning they are a company’s first financial obligations to satisfy in the event of default – ahead of unsecured credit and equity. What is not as commonly appreciated is that the senior secured bond market has grown tremendously over the past decade, particularly in Europe. Interestingly, these senior secured bonds trade at very similar spread levels to their unsecured counterparts. As any high yield manager who has been through multiple credit cycles will know, security in the capital structure has a value, and therefore, especially while the market is not recognizing this differentiation, investors may want to evaluate opportunities to invest in secured debt.
3. Focus on individual credit – or idiosyncratic – risk and opportunity
Managers and investors alike have in many cases benefited from riding the credit beta wave since the global financial crisis, but signs point to idiosyncratic risk having its day in the sun once again. While high yield fundamentals appear stable outside of energy and commodities, a plethora of macroeconomic risks and a general maturing of the credit cycle mean that we may be witnessing a shift to a credit pickers’ market.
The problem is that analyzing individual credit risk for hundreds of issuers requires significant resources – especially considering the four-fold increase in the size of the European high yield bond market since 2009. But over this same time period, banks and many asset managers have shrunk their research departments.
Investors may therefore want to consider investing with managers with large, global research teams. Such resources enable coverage not only of large, well-known credits, but also of smaller ‘off-the-run’ issuers enabling the manager to potentially exploit the market inefficiencies which can be significant sources of alpha generation.
In summary, at Babson we continue to see attractive opportunities across the global high yield spectrum, but investors should not close their eyes and jump blindly into this asset class. In order to position themselves for success, a more nuanced approach may be warranted.
Stuart Mathieson is a portfolio manager in Babson Capital Management’s European high yield investment group. He is speaking at FundForum International on the June 6 panel “Reliable Returns in a Low Yield Environment.”
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