Discussing how investors should be thinking about high-yield fixed income in light of today’s global growth, rates, and inflation environment are Jens VanBrabant, senior portfolio manager and head of European High Yield; Mike Schueller, senior portfolio manager, U.S. High Yield; and Brian Jacobsen, senior investment strategist, with Allspring Global Investments.
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Brian Jacobsen: Hi, I’m Brian Jacobsen, senior investment strategist, and you’re listening to On the Trading Desk®. Today, we’re discussing the global high-yield landscape and how investors should be thinking about high-yield fixed income in light of today’s global growth, rates, and inflation environment. Joining us are Jens VanBrabant, senior portfolio manager and head of European High Yield, and Mike Schueller, senior portfolio manager, U.S. High Yield, who will be providing their insights on this topic. Thanks for being here, Jens and Mike.
Jens VanBrabant: Happy to be here.
Mike Schueller: Thanks for having me.
Brian: We all recognize that bond markets have seen a difficult start to 2022. It sometimes feels like there is nowhere to hide. Investors have been challenged by the three Cs: central banks, conflict, and China. Central banks are starting to remove monetary accommodation. There is conflict in Ukraine. And China’s shutdowns have repeatedly shocked supply chains. It’s been one thing after another and we’re only five months into this year. Mike, can you give us a backdrop on how U.S. high-yield issuers’ characteristics and spreads have changed this year?
Mike: I sure can. This has been one of the weakest stretches in high yield ever. We’re approaching almost our fifth consecutive month of negative total returns, which would be the first time that’s ever happened in the U.S. high-yield market. Before I talk about the quarter, let me just set the stage for a bit. Coming into the year after a late-December rally, valuations were pretty rich at that point. To start the year, we experienced some heavy technical selling as the market repriced the Fed’s (Federal Reserve) rate-hiking path and rates started to rise. However, following the Russian invasion of Ukraine, we saw a little bit of a shift in the selling pressure. Prior to the Russian invasion, the key concerns were inflation and the Fed. And then following that invasion, we saw more concerns in that lower quality of the market, which generally is an indication that there are some growth concerns. Why might that have happened? Well, obviously, there was increased geopolitical risk, but the other issue that came to the fore was yet another global supply chain shock that created the possibility of inflation continuing. Since then, we’ve also had China lockdowns further exacerbating the supply chain problem. The last thing I think is interesting to note is that the new issue calendar has virtually dried up, and that’s really driven by the fact that yields now far exceed the average coupon and there’s very little incentive for issuers to tap the market to refinance bonds.
Brian: That’s some really helpful background. Thank you for that. So let’s now turn to the most popular topic in fixed income recently: interest rates. Let’s start in Europe. So the Bank of England has been hiking rates, but they’re worried about a possible recession in the U.K. later this year. The ECB, the European Central Bank, hasn’t hiked yet, but that could change this summer, even though they’re facing an economic slowdown. So, Jens, can you talk us through how you’re navigating this challenging environment?
Jens: The rates market’s really been driven by, I’d say, two opposing forces. On the one hand, there are really elevated inflation levels, which puts a lot of upward pressure on yields. And on the other hand, you got growth concerns and negative risk sentiment, which are putting yields lower. And if you look at central banks, what they’re doing is they’re continuing on a path of tightening into a really fragile backdrop, and that backdrop is, I’d say, characterized by energy and food-driven stagflation and quite weak Chinese growth, as well. And just to provide some context, Brian, the interest rate futures markets are currently pricing further Fed hikes of 200 basis points by the end of the year. This is roughly 125 in the U.K. and 100 basis points in the eurozone. And so this just gives you an order of magnitude. And the fact that U.S. growth prospects are better insulated from these macro crosscurrents than the European economies obviously explains why the Fed still seems like the standout hawk versus the ECB and the Bank of England. So what does that mean for high-yield markets? Well, I think there’s been a lot of concern year to date that high-yield markets globally will underperform or potentially enter a default cycle and might be a worse investment than investment-grade or government debt. But when we look at past instances of rising rates, we tend to see the opposite pattern, right? Because, typically, during periods of rising interest rates, high yield typically does well and it tends to actually outperform both investment-grade credit and government bonds. And that is really because the asset class benefits from a spread cushion that absorbs the rate volatility and also because the actual underlying economic growth that usually leads the rate hikes in the first place continues to support cash flow generation and, ultimately, companies’ deleveraging capability. So when you look in the past, it’s only when central banks start losing control of the hiking narrative, when inflation risks spiral out of control and banks have tight rates to levels that effectively chock off economic growth and recovery, that’s when high-yield bonds will start to sell off meaningfully and underperform these other segments of the market. So I think that scenario is quite far removed from where we are today. Today, I’d argue that maybe the June ECB and Fed meetings may be a pivot point for risky assets as the hawkish central bank rhetoric may have reached a peak by then and inflation will have likely peaked by then, as well, or be at elevated levels.
Brian: That makes a lot of sense, Jens. Thank you for that. So can you share your perspective on what areas are most attractive to you, then?
Jens: What we’ve seen over the last year and a half, both in Europe and in the U.S. actually, is that the leveraged loan market has actually trumped all other fixed income asset classes in terms of performance. For example, year to date, European and U.S. loan markets are down between 2% and 2.5% versus -9% to -11% for high-yield markets. And we saw a similar difference in performance last year. In Europe, what we’ve seen in the last month, in particular, we’ve seen investors taking some of their level and exposure down to rotate into other parts of the market, such as, for example, short-duration high-yield and even government bonds and investment-grade debt where the yields are obviously a little bit higher now.
Brian: Great. Thank you for that. And, Mike, how about U.S. credit opportunities? With the Fed trying to slow the growth of demand to give supply a chance to catch up, what are the most attractive parts of the market to you today? And I’m particularly interested in some of the things that I’m hearing from investors about how companies might have too much debt and they fear downgrades with lower growth.
Mike: It is worth noting that the fundamentals overall in high yield actually are about as good as they’ve been since the Great Financial Crisis, particularly in terms of leverage and interest coverage. Another thing worth noting is the maturity wall that many investors worry about has been pushed out into the future. We had a significant amount of refinancing issuance last year when market yields were dramatically below coupons and so issuers took advantage of that opportunity to push out maturities, which is certainly supportive. And I think the last thing to note is overall the high-yield market is higher quality than it has been in some time. In addition, we are now approaching nearly 8% yields and spreads at approximately 500 basis points over Treasuries. Historically, that’s about where the average is, but of course, we rarely stay at those averages. And so there remains the possibility that we could see a default cycle in the next few years, particularly if a recession occurs sooner rather than later. So even if we see default rates rise, the loss given default will be much less than the discount and we think that offers potentially an interesting entry point. In general, we would prefer to stay shorter. There’s still a lot of uncertainty out there and being shorter in higher quality can mute that downside volatility.
Brian: That’s some really great perspective there. Thank you. So, now with the time that we have left, do you have some parting thoughts for our listeners? So let’s start with you, Jens.
Jens: I think the market has certainly done an aggressive job of pricing in stagflationary concerns in 2022. But, again, if we look at history, with high-yield credit spreads at today’s level, forward-looking returns over one, three, and five years have only rarely been negative. I mean, this is a market that you can pick your way through with careful security and sector selection and that’s exactly what we’re focusing on with our investment teams. So, yeah, I think we expect some normality to return to high-yield markets in the second half of the year, which is then likely to see spreads tighten from current levels and lead to positive returns over the 12-month period starting from now.
Brian: Great. Thank you. And how about you, Mike?
Mike: It’s certainly been a challenging stretch in all markets and high yield is obviously no exception. As I mentioned previously, we’re approaching our fifth straight month of negative total returns, so really a lot of damage has already been done. Obviously, the outlook remains uncertain. The three Cs have yet to be resolved, but valuations are much improved since the beginning of the year with yields approaching 8% and spreads at nearly 500 basis points over Treasuries. And fundamentals, as mentioned, are in a relatively strong position, even if we are at the beginning of a default cycle. So I can’t tell you that yields and spreads won’t go higher because it’s certainly possible, but we think these valuations represent a good initial entry point for those with longer-term investment horizons of, say, a year or longer.
Brian: Well, thank you, Jens and Mike, for being with us today and sharing your insights.
Jens: It was a pleasure. Thank you.
Mike: Thank you for having me.
Brian: That wraps up this episode of On the Trading Desk®. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, Google Podcasts, or whatever podcast subscription service you use. Until next time, I’m Brian Jacobsen; stay informed.
Disclosure: 100 basis points equal 1.00%.
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