High Yield: A Compelling Risk-Reward Picture for Long-term Investors
By: Chris Sawyer, Adrienne Butler, and Scott Roth, Barings
Markets will likely remain on edge in anticipation of a central bank policy pivot, but high yield continues to present compelling total return opportunities for investors willing to ride out the volatility.
This is an excerpt from NCPERS Spring 2023 issue of PERSist, originally published March 21, 2023.
The list of factors driving uncertainty across financial markets is long. But for longer-term investors, high yield bonds and loans continue to present compelling total return opportunities.
Earnings in Focus
If 2022 was the year of interest rate volatility, corporate earnings will likely take center stage in 2023. As inflation climbed last year, many companies maintained enough pricing power to pass higher costs through to their customers; earnings, as a result, remained more durable than some market participants were expecting. Looking across the high yield universe today, the fundamental picture seems to be darkening. For one, the lagging effect of 2022's rate hikes has started to stress parts of the economy and is beginning to impact aggregate demand. Compounded by still-elevated labor costs, the ability of companies to pass through higher prices is starting to deteriorate, which will likely lead to some contraction in earnings going forward.
The technical picture has also remained challenging for high yield, particular loans, against a backdrop of more challenging liquidity and retail outflows in the U.S. Compounding this, there has been a continued lack of new collateralized loan obligation (CLO) issuance, which has historically accounted for a large portion of loan demand.
On the positive side, most high yield issuers still have the flexibility to continue to service their debt through a period of economic weakness and remain in a stronger financial position today than they would have been before the pandemic. At the same time, the credit quality of the high yield market has improved considerably over the past 15 years—BB issuers comprise 53% of the market, while single-B companies make up 38%.
A HIGHER-QUALITY HIGH YIELD MARKET
Source: Bank of America. As of December 31, 2022.
Attractive Total Return Potential
While the difficult macroeconomic environment is unlikely to fade anytime soon, mild recessions have not necessarily been bad environments for high yield markets in the past. Investors who stayed invested in high yield through periods of volatility, and even economic decline, have historically been rewarded with attractive, long-term returns. This is partly because high yield, unlike equities, does not require strong economic growth to perform well. Rather, what matters more is an issuer's ability to continue to meet the interest payments on its outstanding debt obligations. Slow GDP growth, or even a short period of mildly negative growth, is unlikely to drive significant increase in defaults—particularly across a higher-quality market with solid underlying fundamentals.
In the event of a recession, the potential downside in credit is also likely to be more limited given how challenging 2022 was for most financial markets. While spreads would likely experience some widening from current levels, we do not expect material widening to the extent that total returns would turn negative—particularly given the higher quality of the market and solid fundamental backdrop.
Focusing on the Long Term
In the current environment, investors do not need to take on excessive risk to earn potentially attractive returns. In higher-rated parts of the bond and loan universe, the risk-reward picture remains compelling. However, a credit-intensive approach is crucial—to not only avoiding additional downside, but also identifying issuers that can withstand today's headwinds.
About the Authors:
Adrienne Butler is Co-Head of Barings' U.S. High Yield Investments Group and Head of U.S. CLO Funds. She is also a member of the U.S. High Yield Investment Committee. She is responsible for new CLO marketing and formation as well as existing CLO portfolio management. Adrienne has worked in the industry since 1990 and her experience has encompassed sell-side relationship banking, media and telecom specialty lending, and CLO portfolio management. Prior to joining the firm in 2002, she was part of the acquisition of First Union Institutional Debt Management (“IDM”), where she was a senior analyst in IDM's Loan Research Group. Before IDM, she was a vice president/relationship manager at First Union Corporation and worked in corporate banking at First Union National Bank of South Carolina. She also served as a loan officer at NationsBank. Adrienne holds a B.A. from Furman University and an M.B.A. from University of Notre Dame's Mendoza College of Business.
Scott Roth is Co-Head of Barings' U.S. High Yield Investments Group, Chair of the U.S. High Yield Investment Committee and a member of the Global High Yield Allocation Committee. His responsibilities include portfolio management for various high yield bond total return strategies. Scott has worked in the industry since 1993 and his experience has encompassed fund management, underwriting, leveraged loans and high yield. Prior to joining the firm in 2002, he was a vice president at Webster Bank and was a high yield analyst at Times Square Capital Management. He also served as an underwriter at Chubb Insurance Company. Scott holds a B.B.A. from Western Michigan University, an M.B.A. from the Ross School of Business at University of Michigan and is a member of the CFA Institute.
Chris Sawyer is Head of Barings' European High Yield Investments Group as well as a member of the firm's European High Yield Investment and Global High Yield Allocation Committees. Chris is responsible for the portfolio management of several loan, high yield bond and multi-credit strategies. Chris has worked in the industry since 2005. Prior to joining the trading team in 2008, he was a member of the portfolio monitoring team where he was responsible for the ongoing credit analysis of individual portfolio assets. Chris holds a B.Sc. in Economics and Business Finance from Brunel University.