High-yield bonds: Expect dispersion
The year 2015 was a difficult one for high-yield bond investors, particularly in the US, driven by a collapse in metals and mining on top of the decline in oil prices. This year also looks as though it will be difficult for many investors, with realised US defaults likely.
The fear for high-yield investors is that there is mounting evidence of something more sinister in the form of a potential recession in 2017. The panic seen in February suggests that many investors are starting to position their portfolios accordingly. Marketplace illiquidity may also prove to be an issue, particularly for large bond funds in the US as their predominantly retail investor base flees. By mid-February, US high yield had already lost 5% for the year as investors dumped the asset class, seeking the security of the US Treasury market.
Yet there are reasons to be optimistic and reasons to question whether the strategies of the past are appropriate for the future. The high yields available do provide a cushion for losses in mark-to-market valuations of assets. Moreover, the steep falls in 2015 suggest there is a good chance of a positive return ahead, as, on a historical basis, negative years have typically been followed by positive ones.
But the last couple of years have seen a structural change in the behaviour of the high-yield universe. The post-Lehman years saw the high-yield markets expand rapidly in terms of issuance, but the resources devoted to the marketplace by fund managers were not increased commensurately. That did not matter for a number of years as they were characterised by high-yield spreads shifting downwards, so it did not matter what a manager owned – they were able to ride the high-yield credit beta wave driven by spread compressions.
That phase ended a couple of years ago. Investing in high yield now requires far deeper analysis than just following an index, particularly given the bifurcation in the marketplace. If the US index is yielding 9%, it hides the fact that the tightest half is giving 5.7% whilst the widest is paying 13%. The standard benchmarks are riven by problems including over-concentration and differing views on the inclusion of emerging market stocks, among others.
That also makes comparisons between the US and Europe difficult to make based on indices alone, particularly given that the composition of the two markets is so strikingly different. For investors, it means that whilst global high yield can still certainly offer opportunities, what a manager can and should offer will be different from what the benchmark indices are presenting, and that can be seen in the huge dispersion in performance.