Morningstar's 'Perspectives' series features guest contributions from third parties such as asset managers, academics and investment professionals. The below are excerpts from an article written by Wes Sparks, head of US fixed income at Schroders.
Returns in the high teens are not achievable again in the coming year
The performance of high yield in 2012 will be a tough act to follow. High yield bonds produced returns in the high teens, beating all other fixed income sectors as well as most equity indices in 2012. While the absolute level of high yield bond returns will most assuredly be more modest in 2013, returns relative to other asset classes may still look strong, and there should be more opportunities for the active investor to add value by selecting the right credits and the right industries to invest in.
More so than any time in the past three years, there will be a growing dispersion of returns across issuers within the high yield universe and it will matter what an investor doesn’t own as much as what is owned in the portfolio. This will be an environment where merely having index-like exposures won’t be the best approach, as some of the largest issuers are debt-laden credits that may materially underperform in a slow growth environment.
Prospects for 2013
Returns in the high teens are not achievable again in the coming year—given low yields as today’s starting point—but a total return for high yield bonds in the +7.0-7.5% range is quite likely. As 2013 begins, the global high yield index has a yield-to-worst of only about 6.1% but the current yield is 7.4%, reflecting the average coupon divided by the average price of the bonds in the index.
No major asset class comes close to providing the yield available in the high yield market. In hopes of getting a positive real rate of return on investments, investors will be forced to consider extending duration, moving down in credit quality, buying less liquid securities, and/or accepting increased structure risk (such as investing in bonds with less call-protection or fewer protective covenants in order to gain a pick-up in yield). Of course, investors need to assess expected total return and potential volatility, and not just the yield, in order to determine the relative attractiveness of prospective investments.
The question for the high yield asset class is whether there will continue to be sufficient positive forces to contribute to modest price appreciation in addition to the yield, or whether negative catalysts will emerge to drive price declines so that the realised return would be lower than the yield. It will be important for investors to monitor key signposts in the coming year for indications that fundamental or technical trends are being reinforced or whether they start to deteriorate. We expect that the total return for the global high yield index will be in the range of 7.0–7.5% in 2013 under our base case scenario—slightly more than the yield-to-worst of the asset class but in line with coupon income. While a temporary market correction in the coming months would not be surprising, we believe a bear market—accompanied by a material increase in the default rate or with a dramatically higher risk premium that would drive high yield returns to be negative—is unlikely in 2013.
Macroeconomic and Credit Trends for the Year Ahead
There are several key themes that we believe will dominate in 2013:
- Monetary policy will remain highly accommodative to offset the impediments to economic growth from more restrictive fiscal policy in the US and Europe. There will be on-going quantitative easing programmes by the Fed and other central banks around the world.
- Potential changes in tax policy and regulatory policies will constrain companies from significantly increasing investment in capital or labour, contributing to a slow growth environment.
- Inflation and inflation expectations will remain subdued.
- Default rates will remain benign, so that overall market-wide losses due to defaults remain adequately compensated by high yield bond spreads over US treasuries.
- Investors and asset allocators will continue to be attracted to the yield of the global high yield and emerging markets sectors, and there won’t be a significant rotation out of credit into equities in 2013 even though there will be a lot of media attention on that possibility.
- Changing investor perceptions about the trajectory of economic growth and the effectiveness of policy action will contribute to periodic waves of volatility.
Changing Market Environment
As systemic risk and the “risk-on/risk-off” market mentality of the past three years begin to subside, idiosyncratic credit risk should rise and individual credit selection will become more important. With central banks proactively using monetary policy to offset potentially deflationary threats globally, the magnitude of a negative tail scenario is not as severe as it previously had been. This can allow investors to focus more on differentiating between companies that are fundamentally sound and those that are facing headwinds.
Industry Selection
We would also expect the dispersion of industry returns to increase as industries with healthy dynamics outperform those industries that are experiencing either secular decline or negative cyclical forces—such as paper, publishing, and certain segments of technology impacted by significant shifts in consumer spending trends.
We are focused on investing in industries where deleveraging is still occurring, where there are stable profit margins or where an industry is consolidated with a few large companies exerting price discipline. We also seek out companies that have pricing power because of strong brand names, or large order backlogs which contribute to earnings visibility, as well as where companies have some control over input costs or the ability to pass on cost increases to customers. Industries we currently favour—where we find solid fundamentals and reasonable valuations—include cable, wireless, construction machinery, oil field services, retailers (through specialty retailers) and life insurance.
Company Focus
We had previously favoured globally-oriented companies, but in many cases we now favour US domestically-focused businesses—particularly those that have stable cash flows and moderate leverage. Cyclical companies that are still highly levered, three years into the economic recovery, may have a difficult time in a slow growth environment; we are avoiding them as a result.
In terms of credit quality, we expect that single-B rated credit will outperform other ratings categories in 2013. The more highly-leveraged and often more cyclical credits rated CCC and CC may have a difficult time deleveraging any further in the slow growth environment we expect in 2013. Double-B credit may perform reasonably well but not keep up with the return generated by Bs, simply because of the lower yield and the fact that many BBs carry high prices and have become call-constrained. As a result—rather than a strategy of focusing on maximising yield, or alternatively a defensive stance focusing on the higher-rated, interest-rate sensitive credit—a middle-ground exposure in high yield credit may lead to the best returns in 2013.
In seeking returns in 2013, we are more inclined to move down the capital structure and invest in subordinated debt of better quality companies than to move down in credit rating to invest in weaker companies to pick up yield. Issue selection will likely play a greater role in generating returns in 2013 than has been the case in recent years when a “risk-on/risk off” mentality drove valuations across financial markets and kept correlations of price returns high.
Favouring US and Emerging Markets
Regionally, we prefer the US to Europe. This is because US economic growth is stronger than that in the eurozone and bank lending conditions are better and improving in the US. Also, market liquidity is better in US high yield, particularly during market corrections, and European valuations are no longer compelling now that pan-European high yield spreads are more than 20 bps tighter than US high yield.
At the same time, we see growing opportunities in emerging markets corporates—because of stronger economic growth than in developed markets and because of surging new issue volumes which permit investment in a greater variety of companies and countries. We like South America (with a focus on Mexico and Brazil in particular, where consumer and infrastructure plays look particularly appealing), some Eastern European high yield credit and Asia only very selectively. We prefer industrials and consumer credits in emerging market corporates over financials and real estate.
Focus on Risk
When we consider the risks to our constructive view on potential high yield returns in 2013, we need to evaluate where possible surprises might arise as the year progresses. Investors will need to keep an eye on valuations to ensure that we continue to be amply compensated for risks incurred. Key risks for the high yield market are default risk, interest rate risk, event risk and changes in the risk premium. We believe that the first three risks will remain sufficiently benign so as to not be key drivers of overall high yield.
The global high yield index provides a spread versus duration-matched US treasuries of just over +500 basis points, which remains well wider than the tights of +225 bps experienced in the spring of 2007, and should be more than ample to cover losses due to defaults. Both interest rate risk and event risk are greater potential threats for investment grade credit than for high yield. So, as has been the case over the past two years, material changes in high yield bond spreads will most likely be driven by changes in the risk premium in the coming year as investor risk appetites shift in response to economic data or official policy action.
Such periods of volatility can create buying opportunities for investors who are not yet at their target exposure and who seek incremental yield in their portfolio. The overall market environment in 2013 will be one that should remain hospitable for high yield bonds; there may be the occasional short-term correction but a protracted bear market is unlikely. The credit cycle is now approaching its fifth year since recovering from the 2008-09 default wave; high yield credit fundamentals remain solid, and lingering macro risks have kept management teams cautious with respect to balance sheet and liquidity management. 2013 may be another year that global high yield, like corporate bonds in general, remain in the sweet spot.
Schroders Disclaimer
The views and opinions contained herein are those of Wes Sparks, Head of US Fixed Income, Schroders and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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