After a dramatic first half of the year where global high-yield bond funds lost 7.3 per cent of their value, the second half of last year saw a small gain of 1.4 per cent, in euro terms. The consensus among fund managers remains that despite recession fears, we will not see a wave of defaults in 2023 either.
The fourth quarter of 2022 provided some relief in an otherwise difficult year for high-yield bond funds. Consequently, the past three months saw a significant tightening of credit spreads. The ICE BofA US High Yield Index Option-Adjusted Spread closed December at 481 basis points, down from 543 basis points at the end of the third quarter. The European equivalent saw a decline of 127 basis points to 498 basis points over the past quarter. In the first two weeks of 2023, the spread fell further to around 420 basis points in the US and 460 basis points in Europe. By comparison, the spread on US investment-grade bonds with a credit rating of BBB fell to 172 basis points.
The last peak in high-yield bond spreads was around 600 basis points in the US in early July 2022, well below the 1,000+ basis points in 2020 and even the 890 basis points in February 2016 when traders speculated on a wave of bankruptcies in the US oil and commodity sectors following a sharp fall in oil prices.
No panic
So real panic did not last long last year, especially as a large proportion of investors in high-yield bonds predicted that defaults would remain below the long-term average. Many companies managed to refinance their debt on favourable terms in the previous two years while the quality of debt securities in the US high yield market is much better now than during the financial crisis of 2007-2008. This is partly the result of an increase in the number of «fallen angels» in the benchmarks. Indeed, during the corona crisis, the credit rating on a large number of bonds was downgraded from BBB to BB. Nonetheless, the spread on US bonds rated CCC or lower also remained well below the peaks of 2020 and 2016 by up to 1,289 basis points in 2022.
Strategists rather neutral
Clearly, the ability of central banks to fight inflation was the biggest performance factor for most asset classes in 2022. Logically, interest rate-sensitive assets such as long duration bonds and growth stocks were the main focus. Presumably, that same theme will remain top of mind among investors during the first half of 2023.
Yet the calmness in high-yield bonds remains noteworthy as many strategists and economists predict a (mild) recession for 2023. Historically, a recession in the US has often led to a significant number of defaults in the high-yield market. This often leaves the outlook for this asset class among strategists at Neutral.
BlackRock Investment Institute is one of them and Schroders’ multi-asset team is now negative on US high-yield bonds following tightening spreads. It fears the asset class is vulnerable given its relative size should the US economy start to slow sharply. Unlike the US, the team does see value in European high yield bonds. While a negative scenario with slowing growth and high inflation is largely priced in, Kempen also sees downside risks, such as lower earnings growth and rising defaults. According to Robeco, the next recession could turn out to be less mild than currently priced into spreads. Still, high-yield bonds look more attractive than equities, according to the fund house. NNIP also remains cautious at the start of the year and neutral on the asset class.
Top 5
For this week’s Top-5, we look at investment funds in the global high yield bond Morningstar Category, as measured through the distribution fee-free fund class available in the Netherlands. These five funds showed the best performance in 2022 and all recorded positive returns, while the average fund within this category lost 5.5 per cent of its value.
The UBS (Lux) Floating Rate Income fund is on the top step and ended the year in the second percentile of its global high yield bond Morningstar category. The fund is managed by Matthew Iannucci, Anaïs Brunner and Branimir Petranovic. Iannucci, the global head of high yield developed markets has worked for UBS for 26 years and is based in Chicago. Brunner and Petranovic have also worked for the Swiss asset manager for many years. About 4% of the fund’s assets were invested in the UBS (Lux) Short Duration High Yield Sustainable strategy at the end of last year. Top positions include Ford Motor and JPMorgan Chase. The managers remain cautious given the increased volatility, tightening monetary policy and recessionary risk and favour higher-quality credits within BB. At the end of December 2022, 41% of the portfolio was invested in BB credits or better, including 8.9% in BBB or higher, compared to 59% for the average fund within the category.
Also still in the top five is the M&G (Lux) Global Floating Rate High Yield Fund managed by James Tomlins. The fund already finished 2021 in the top decile of the global high yield bond Morningstar category and just continued that trend in 2022, partly due to its rather defensive credit selection with lower exposure to inflation-sensitive companies. However, in 2020 and 2019, this strategy underperformed by finishing in the bottom quintile of its category each time. This fund was rated Neutral by Morningstar analysts until recently, but coverage was terminated due to insufficient conviction in the strategy’s potential to beat its category benchmark.
The Ostrum Short Term Global High Income fund also performed excellently in 2022, ending the calendar year in third place. However, in previous years (2019-2021), the strategy did not fare as well. The fund has been managed by Erwan Guilloux from Paris since 2015. The Natixis manager focuses on researching individual issuers and is supported by a team of credit analysts. The strategy targets a short duration of less than two years and has no formal benchmark. According to Guilloux, several segments of the market are now attractive especially in those BB credit-rated bonds that have the potential to be upgraded to investment-grade. According to him, the spread between Bs and BBs is not wide enough. At the end of December, the duration of this strategy was 1.78 for a yield of 6.59% (hedged in USD).
Top 5 High-Yield Bond Funds YTD:
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.