High yield bonds: looking beneath the bonnet

By Tom Ross, Corporate Credit Portfolio Manager at Janus Henderson Investors

It has been quite a journey from the very bleak days of early 2020 to the close of 2021. During that time, credit spreads (the additional yield of a corporate bond over an equivalent government bond) have declined from decade-high wides. Throughout, the monetary policy backdrop has been supportive, with low interest rates and asset purchase programmes helping to anchor financing costs at low levels.

Meanwhile, credit conditions have been broadly favourable as the economy has picked up and companies have sought to reduce high leverage (debt levels) as cash flows improve. 2022 may be notable for the policy tailwind dissipating, with individual credit performance mattering more to overall returns.

Fork in the road

Central banks have already signalled their shift to tighter monetary policy, although the trajectory may be affected by COVID variants if any of these prove to be concerning. We anticipate market volatility in the first half of 2022 fuelled by concerns about inflation.

We think inflation could subside later in 2022 provided that supply chains reconnect, and the disinflationary demographic and technical forces reassert themselves; this should help limit the extent of any interest rate rises.

High yield bonds have historically performed better than investment grade bonds in an inflationary environment and we would expect this to remain the case, but we are cognisant that starting yields and credit spreads are relatively low. A key area of focus for us is differentiating between those companies that are able to pass on higher costs and those that could suffer margin erosion.

We are paying particular attention to the crossover space – the credit ratings area that surrounds the border between investment grade and high yield. Often a source of pricing inefficiencies, we believe this area is ripe for more companies to make the transition from high yield up to investment grade status, including several of the cohort of issuers that were downgraded during the peak of the COVID crisis in 2020.

The difference between the spread on a BB rated high yield bond and a BBB rated investment grade bond remains high, offering the potential for spread tightening as certain issuers are progressively upgraded. In fact, the spread ratio (dividing BB spreads by BBB spreads) is near a decade high, indicative of stronger relative value within BB bonds.

While we believe we are still mid-cycle, credit spreads are closer to late-cycle tight levels, even accounting for the widening that took place in late 2021. There is some creep of bad behaviour among issuers, with debt again being used to fuel takeover activity.

Meanwhile, covenant quality (the terms attached to debt such as a step up in coupon paid on a bond if a company breaches certain financial metrics) has deteriorated.  This often happens when bond issuers and investors are more confident, but we need to be careful that yields and terms reflect a reasonable balance against risks, hence why rigorous credit analysis will be even more important in 2022.

Few breakdowns

We anticipate companies seeking to refinance while yields remain relatively low, particularly to replace more expensive debt issued at the height of the pandemic emergency. The very low default rate should persist. Absent fresh severe lockdowns, ongoing recovery in the global economy means we would be surprised if the global high yield default rate were to go above three per cent in 2022, which even then would be well below the 20-year average of close to four per cent.

The Chinese real estate sector may remain a source of volatility as markets establish how strict authorities will be in tempering debt levels. We continue to believe that, in aggregate, the US as a region offers the most favourable mix of yields and robust domestic economic growth, although European spreads are looking increasingly attractive after recent widening.

Cleaner engines

While the COP-26 climate change conference will be in the rear-view mirror, the route to a more sustainable world remains clear. We expect sustainable debt to remain popular both with issuers seeking to burnish their environmental, social and governance (ESG) credentials and investors demanding their capital is allocated to companies that care about these matters. Our view is that sustainability is a long-term theme of finance and companies that pay attention to ESG are likely to be rewarded with lower cost of capital.

Ultimately, we think that negative real yields across much of fixed income will continue to drive investors into higher yielding parts of the market. Valuations are the element that constrains our positive view as strong demand for high yield bonds means they are no longer cheap. This leaves the market susceptible to periods of heightened volatility, although we would view those as potential buying opportunities.

This article is issued by Jesmond Mizzi Financial Advisors Limited. The contents of the article are the author’s views and should not be construed as advice and may not reflect the other opinions in the organisation. They are for information purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector.

Janus Henderson Investors is the source of data unless otherwise indicated. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value. Janus Henderson is represented in Malta by JMFA. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group.