Given how 2019 started, and how different the world felt back then, few people backed high yield, and even fewer would have predicted that the year would turn out to be one of the best on record in terms of returns delivered by the high yield market. Global high yield (as measured by the ICE BofAML Global High Yield index) returned 12.32% in sterling terms (14.52% in US dollars) in 2019. So the natural question is what can it do in 2020?
Let’s get the bad news out of the way first; in 2020 it is extremely unlikely that high yield will generate anything like the returns we have seen in 2019. The bond mathematics simply aren’t on the sector’s side in this regard. The valuation picture within global high yield remains one of the most challenging parts of the market. The government option-adjusted spread (OAS) on the ICE BofAML Global High Yield index currently stands at about 425 basis points (bps), with an effective yield of 5.5%. If one compares either of these metrics to the long-term averages for the asset class, they are clearly expensive versus history. In other words, it doesn’t seem plausible to rely on a further significant tightening of credit spreads to drive total returns in 2020, and although we note spreads have traded at significantly tighter levels over this cycle, it feels hard to make a compelling valuation argument, given the asymmetric potential return profile. So what are the upsides?
Firstly, high yield does still offer you an attractive income based return in a world that is largely bereft of yield, particularly when compared to that on offer from investment grade corporate bonds or governments. There are still pockets of value too; higher quality BB-rated bonds trade tight, but there are still plenty of opportunities in the lower rated space that can be unlocked by careful credit analysis. The recent trend of dispersion here plays into our hands as active, fundamentally driven investors. A more volatile world offers us more opportunity to deliver value through our rigorous investment process. Furthermore, this frequently misunderstood asset class does offer some defensive characteristics too; it has a high breakeven level (the amount by which spreads need to widen in order to deliver a negative total return), it has a low interest rate sensitivity, and a low correlation to other asset classes. Global high yield rarely has a down year (just two out of the last ten have delivered a negative total return), and when it does, it tends to recover those losses extremely quickly.
From a corporate fundamental perspective, the backdrop has continued to deteriorate at the margin, with key credit metrics such as leverage and coverage worsening, albeit from very strong levels and at a very slow pace. This is clearly not a favourable trend for credit investors, however defaults do remain low, and are generally contained to idiosyncratic stories, which is why an active management approach to the asset class is imperative. Without a sharp and sustained growth slowdown it is hard to see where a significant pick-up in defaults comes from, and given there are tentative signs of a bottoming-out of some of the macroeconomic data, a slightly more benign 2020 growth outlook will be supportive for the asset class.
Last, but most certainly not least, central banks continue to deliver sustained supportive policy to markets, effectively providing an underlying bid for risk. Our approach this year is to favour a more beta-neutral position overall, and to use security selection, particularly within lower rated bonds, to drive returns. In summary, whilst we can’t expect more of the same in terms of the stellar returns seen this year, we can expect high yield to go back to doing what it does best: deliver a solid carry-driven year, providing investors an attractive, risk-adjusted total return, and act as a good portfolio diversification tool.