High yield continues to find itself at the centre of a ‘valuations conundrum’, according to Thomas Hanson, head of Europe high yield at Aegon Asset Management.
Responding to the recent bond market volatility, Hanson notes that there is rightly an element of caution in the market, but that the fundamentals remain relatively robust for now.
“High yield fundamentals have been in very good shape recently, although we are beginning to see some deterioration at the margin,” he says. “The important thing to remember is that it’s coming from a position of strength. High yield balance sheets have been quite well managed over recent years and aggregate credit quality is certainly higher than it has been in times past.
Defaults are almost inevitably going to tick up, given that they’re coming from such a low rate. But in terms of the ultimate peak in defaults, it might be lower than in previous cycles due to the fundamental position of strength that the market is coming from.”
According to Hanson, it’s in valuations that the outlook becomes more complicated.
In terms of valuations, it’s quite a difficult picture currently,” he says. “On the one hand, yields are very attractive. The effective yield on the global high yield market is around 9.0%. Looking at historical peaks in yield, there haven’t been many opportunities to access the market at this level – and when there have been, subsequent forward returns have tended to be extremely positive.
On the other hand, you always need to think about the market in spread terms too, because spread is pricing in the credit risk inherent in the market – and we would contend that spreads are perhaps a little tighter than we would like at this point in time. The reason for that is largely the strong technical environment, and the result is a valuations conundrum: attractive yields, but spreads only really about fair value at this point, even with the recent back-up”
With this in mind, Hanson believes that investors need to focus on the higher-quality end of the high yield market, despite default levels remaining relatively low compared to the past.
In terms of how investors respond to the current dynamic, there is considerable caution in the market, so it’s fair to reflect that in portfolio positioning. Our own reaction has been to move up in quality. We have been overweight in the lower rated CCC and single B part of the market in recent quarters. Now, we’re recycling that risk, moving up in quality, going into the BB part of the market and putting a lot of investment grade in the portfolio.
We can have up to 20% investment grade at any one time and we’re currently at 15%, which is quite high for us historically. This is reflecting that degree of caution, which is the right way to position a portfolio for the current market outlook.”
Hanson points out that following high yield benchmark does not make sense from a philosophical standpoint, and that investors should be focused on an active approach to high yield investing.
Following the benchmark doesn’t make a great deal of sense in the world of high yield, where the largest index weights are determined by those companies that have the greatest amount of debt outstanding” he says. “In order to deliver truly differentiated performance, you need to construct a portfolio that looks very different to the benchmark. This means delivering a high active share and getting the very best ideas from around the globe, including US, European, and Emerging Market high yield.”
Looking forward, Hanson believes that a ‘bottom-up’ approach will be essential. “In terms of performance over the next couple of months, it’s always about the bottom-up approach, but this is especially important at this point in time and given where we are in the cycle. This means focusing on strong single-name idea generation and avoiding losers.
The market is bifurcating into haves and have nots. Avoiding the lower-rated CCC part of the market and concentrating on the higher-quality ideas is key for the months ahead.”
