The US Bloomberg Barclays High Yield Index has already risen by more than 30% since its low in March. But the big rally is now over, with the remaining opportunities now primarily in reopening trades and rising stars, according to Walter Kilcullen, manager of the Legg Mason Western Asset US High Yield Fund.
‘The risk premiums on the US high-yield market are now around 400 basis points, and with that starting point it will be difficult to achieve another high single-digit return in 2021,› says Kilcullen from his home in Los Angeles, where he’s currently under stay-at-home orders due to a coronavirus emergency in the city.
The fund manager expects that the default rate, which is now around 7.5%, can still come down slightly to 6-6.5% next year, but not by much more than that. This is despite the imminent arrival of a vaccine against the coronavirus. ‘The markets are already largely ahead of this. A strong economic recovery next year is therefore already priced in›, says Kilcullen.
The fund manager expects a return on the US high-yield index of around 5%, which sounds modest compared to some predictions for the stock market. High-yield bonds are also relatively strongly represented in cyclical sectors, which will benefit excessively from economic recovery.
Reopening trades
There are indeed opportunities to boost your return a little, for example by investing relatively more in so-called reopening trades. ‘These are credits issued by, for example, hotel chains, aeroplane and cruise companies and casinos. In part, we have already picked up such deep cyclicals, often at prices that we last saw at the height of the financial crisis. Even now, however, we are still talking about hundreds of basis points of spread in comparison with, for example, consumer goods or health care.’
Kilcullen also regards energy, one of the largest sectors within US high yield, as a reopening trade. ‘Fortunately, we were underweight in the energy sector at the start of the pandemic. Then in April a number of oil and gas companies were downgraded to high-yield, which was the starting signal for us to start buying again. We are now only slightly underweight.›
Even now, investors are being rewarded generously for taking on debts in the energy sector, but there are good reasons for this. ‘Energy trades at a premium of 240 basis points. This is partly due to the expectation that the rules for the oil and gas industry will be tightened up again under the new Biden government,’ notes Kilcullen. ‘[President] Biden will be much stricter when it comes to fracking and allowing new oil and gas drilling. There will also be more focus on environmental regulations.› The fund manager is not particularly positive about oil and gas prices either. ‘The only commodity where we see a positive supply/demand ratio is copper.’
Rising stars
In addition to reopening trades, Kilcullen also sees opportunities in so-called rising stars: credits that have recently been downgraded but can quickly be promoted back to investment grade again. ‘The credit rating agencies have always been quick to downgrade, which is why we saw a lot of fallen angels in April. But many of these will soon be able to return to investment grade. These companies still have excellent access to financial markets thanks to the incentives provided by the Fed and the government, and can continue to fund themselves easily. You will see that the balance sheets of these companies will soon look like investment grade again when the economic situation returns to normal›. Examples of such companies are Kraft Heinz and Ford.
Kilcullen also finds CLO’s a particularly attractive investment category. ‘You can easily get a spread of 8.15-25%, with an average credit quality of BB. BB CLO tranches are so attractively priced because there is extra leverage on them. That’s why you have to take an extra close look at them and make sure you only deal with the right manager.›
Kilcullen’s fund currently has an exposure of about 4% to CLO›s. ‹We’re constructive, so looking to opportunistically add where it makes sense. CLO tranches are diversified, so no one manager accounts for a large percentage of fund assets. Our holdings skew higher quality in nature, trading with tighter bid/asks than instruments of lower credit quality and less liquidity.› The fund also has a 9% allocation to senior secured bank loans.
Kilcullen is convinced that by allocating to these high-yielding CLOs and bank loans, substantial exposure to reopening trades and rising stars, he can beat the index next year. ‘This way we should still be able to achieve a return of 6 to 7%.’