Our CIO has a saying that we like to keep in mind: “investors eat yield, not spreads.” There is a real logic there because, as much as we like to talk about tightening spreads and all of that data, ultimately yields are what people use to look at fixed income because its more indicative of expected future returns.
A favourable backdrop
Faced with today’s uncertain environment, investors are increasingly considering what high yield bonds can bring their portfolios. This comes at a time where the actual asset quality of the high yield space is near all-time highs with defaults trading below historic averages and expected to move lower.
For instance, with the former we used to see around a quarter of the space taken up by CCC-rated debt but this has more than halved in recent years. There has also been a pick-up in liability management exercises (LMEs) and even though these are nearer the distressed end of the spectrum, it actually means that overall lenders’ recoveries on a secured basis have improved significantly, and businesses have bought themselves greater runway.
A strategic move
Of course, as professional investors we need to look beyond the eye-catching yields and take into consideration what spreads are telling us about the market. We have seen some significant spread tightening and – strictly from a valuation perspective – sometimes these opportunities are not overly attractive. However, when considering the decrease in defaults and increase in credit quality, we are comfortable with it being more of a strategic asset allocation whereas it used to be more tactical. The term we’ve used internally is the asset class itself has been “upgraded” in a historical context.
A lot of institutional investors operating in the space are doing so within constrained mandates or having to manage portfolios in line with a benchmark. This can be a disadvantage given the macroeconomic opportunities being presented. Often in such periods of stress caused by issues such as geopolitical tensions, price dislocation can occur in pockets of the market and investors tend to over penalise temporary sector headwinds.
Fortunately, we employ a different approach with our Global High Yield strategy.
Investing with autonomy
Within the Global High Yield strategy we are index aware but do not use this as a guide to portfolio construction. Ultimately, we want to generate security selection alpha and we believe this is best done through bottom-up fundamental analysis. We differentiate between the sectors with real structural challenges and those currently experiencing transient setbacks to find the best pockets of opportunity.
For example, we’ve found a lot of value in the single B-rated high yield space in Europe. And elsewhere we’ve been able to analyse LMEs, with many occurring in the communications sector, with some of these presenting attractive value. After undergoing an LME, these businesses often come through the other side with better covenants and collateral, which present a stronger proposition to invest in.
Though we do have some issuer exposure limits, we use our proprietary scoring system to help dictate allocation sizes. This focuses on fundamentals, technical and valuations, or our FTV system. We use this to rank, score and weight each opportunity on a scale of 1 to 10 which then dictates how much we will own. This also dovetails with our ESG scoring system, which we find to be a valuable part of our analysis work.
The aim is to be dynamic in position sizing and ensure capital is being allocated only where our conviction is supported by fundamentals and catalysts within a trade. This helps us run a diversified portfolio (with around 150 different issuers across a global reach) and maintain liquidity. We do not possess structured notes or structured bonds, and we consistently maintain an exit strategy for each holding, allowing us to liquidate and progress if necessary.
Expand horizons for Yield with Principal Asset Management: Global High Yield Strategy | Principal Asset Management
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