High-yield bonds are not equal. In the US market this year, the difference in spreads between bonds with credit ratings of CCC and below versus BBs rose from 4.6 percent to 9 percent.
High-yield bonds corrected like other assets this year as concerns about rising inflation, interest rate hikes and an economic recession flared up. By the end of October, the effective yield of the ICE BofA US High Yield Index had risen to 8.9 percent from 4.4 percent at the beginning of the year. Over the same period, the spread against US government bonds had widened from 3.1 percent to 4.6 percent. The spread peaked at nearly 6 percent in early July but has since hovered around 5 percent not far from its monthly average since 1997.
Spreads in CCC widened
However, the spread of US bonds with a credit rating of CCC and below rose much faster than less risky segments of the high yield bond market, from 6.8 percent at the end of last year to 12 percent at the end of October. The spread of US high-yield bonds with a credit rating of BB, the highest within the universe, widened to almost 3 percent from 2.1 percent at the beginning of this year. Those with a credit rating of B climbed from 3.5 percent to just 4.8 percent over the same period.
The effective yield on the riskiest bonds grew steadily to 16.3 percent at the end of October, double the 8 percent at the end of last year. In March 2020 and February 2016, yields briefly rose above 20 percent before falling rapidly again.
Opportunities
T. Rowe Price strategists believe that high yield bonds can currently offer an attractive yield advantage over equities, especially if the latter’s earnings figures were to be adjusted downwards. Like other managers we spoke to, T. Rowe Price believes that credit quality within the universe has improved since the end of the financial crisis and issuers generally have more cash and less debt on their balance sheets. Although earnings could fall during a recession, they believe default risk will remain limited. Fitch Ratings forecasts that the default rate on high-yield bonds in the US will end up at 2.5 percent-3.5 percent by the end of 2023, below both the historical average of 3.8 percent over the past 21 years and 5.2 percent in 2020. What also helps is that many companies refinanced their debt in the past two years, extending their maturities on favourable terms.
Top 5
For this week’s Top 5, we look at investment funds in the Morningstar Categories Global High Yield Bond, EUR High Yield Bond and USD High Yield Bond whose distribution fee-free fund class is available in the Netherlands. On average, funds within the USD high yield bond Morningstar Category held 11.3 percent of their assets in bonds with a credit rating below B compared to 4.8 percent for the European equivalent and 8.1 percent for the global universe as of end-September 2022. Since the end of 2011, the percentage in the US has mostly fluctuated between 10 percent and 15 percent. The regional differences are partly due to the composition of the market, such as for example energy taking a larger share in the US than Europe).
These five funds maintained the largest allocation to high-yield bonds with credit ratings lower than B.
AXA WF US Dynamic High Yield Bonds fund
In first place we find the AXA WF US Dynamic High Yield Bonds fund. This strategy is managed from Connecticut by Michael Graham. The fund benefited from being overweight in the best-yielding part of the market in October. This more aggressive positioning worked extremely well in years of highs such as the 2019-2021 period where the strategy finished in the first decile of its category each time. However, over the first 10 months of this year, the fund finished in the 72nd percentile of the USD high yield bond Morningstar Category. It closed last month with a yield-to-worst of 12.25 percent compared to 9.06 percent for the ICE BofA US High Yield benchmark. Graham does not foresee a severe recession or a sharp rise in the default rate of US high yield issuers to well above the long-term average and therefore holds little cash in the portfolio.
T. Rowe Price’s US High Yield Bond
Kevin Loome has been at the helm of T. Rowe Price’s US High Yield Bond strategy since 2018. He has more than 30 years of experience within the industry and was previously head of US Credit at Henderson Global Investors. At the end of September 2022, the fund was overweight 7.6 percent and 15.3 percent in B- and CCC-rated credits, respectively, while it was underweight 29.2 percent in BBs versus the ICE BofA US High Yield Constained benchmark. The top issuers at the end of September were LSF0 Atlantis Holdings active in retail and Citgo Holding and Occidental Petroleum within energy. The latter sector holds 7.1 percent, making it the largest sector within the portfolio. Loome currently holds 6.5 percent of assets in cash. Like quite a few funds with a lower credit profile, 2022 looks set to be a difficult year. The strategy finished in the last quintile of its USD high yield bond Morningstar Category over the last 10 months of 2022.
Pimco GIS US High Yield Bond
Pimco GIS US High Yield Bond deserves investors’ attention, according to Morningstar analysts, as it benefits from experienced manager Andrew Jessop and a sizable group of more than 50 analysts. Moreover, following the departure of co-manager Hozef Arif in July 2019, Jessop was joined by Sonali Pier, a member of Pimco’s leveraged credit team since 2013 and lead manager of the multi-sector credit strategy Pimco Diversified Income since 2017. Jessop’s approach is disciplined and although the exposure to bonds with a credit rating below B is a lot higher than most competitors (21.4 percent versus 11.7 percent for the USD high yield bond Morningstar Category as of end-June 2022), the portfolio remains well diversified. Moreover, Jessop prefers the better-positioned companies in that rating category. Over the years, Jessop and his team have managed to spot what they believe are mispriced bonds and avoid problems. For example, he expressed concern about excessive debt in the energy sector before oil prices plunged in late 2014. This strategy receives a Silver rating from Morningstar analysts.
Top 5
Thomas De Fauw is a manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds on the basis of quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners and ranks five investment funds or providers each week.
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