Getting the balance right in today’s high-yield market

In our last post from March, we recommended a slightly defensive risk posture for high-yield investors, with a focus on individual security selection. In our view, today’s high-yield bond market requires a carefully balanced approach. We remain selective with a modestly defensive risk tilt given rich valuations, while recognizing that low spreads may last longer thanks to ongoing monetary and fiscal support. We will watch for signs of central banks tightening or deteriorating liquidity before turning more defensive.

Macro environment: Positive

• At the time of writing, short-term economic data and corporate earnings are as good as it gets, thanks to the stimulus. We expect a modest slowdown into the second half of 2021.
• Inflationary pressures are building across both emerging markets (EM) and developed markets (DM), with price rises potentially spilling over from goods into services. Policymakers view these pressures as a transitory phenomenon, but we will monitor to determine whether they prove more enduring.
• We are concerned about these dynamics and, broadly speaking, would caution investors to keep duration below that of the high-yield benchmarks.
• Global liquidity, while still abundant, has peaked. We will scrutinize liquidity conditions for signs that could lead to increased market volatility.
• The upturn in the commodity cycle may help some EM economies. We note select instances of tightening, notably rate hikes in Brazil and Russia and Chinese regulators’ renewed focus on deleveraging and suppressing speculation.

Corporate fundamentals: Neutral

• The quality of new issuance is deteriorating as investors hunt for yield, while the rise in stock buybacks and capex announcements suggests that companies have begun to prioritize shareholders over bondholders.
• Defaults remain very low and have continued to decline recently.

Market valuations: Negative

• With spreads now below pre-pandemic levels, total returns are likely to be more dependent on the direction of government bond yields.
  
• Credit selection is more key than ever, given the lack of differentiation. Valuations of leveraged loans and bonds have largely converged and spread compression is acute, even in the low-quality CCC-rated segment of the market (Figure 1).

Figure 1

• These low spreads may last for a prolonged period, as we are still emerging from a recession.
• EM high yield looks attractive relative to DM, but this is largely driven by the Chinese real estate sector. We think this warrants a very selective approach, given strong credit growth and the current uptick in defaults in this region.
• We see the few localized market sell-offs (Turkey, China, Brazil) that have occurred so far as idiosyncratic stories rather than a systemic risk.

Market technicals: Negative

• Investor positioning generally remains stretched, with the Credit Suisse Global Risk Appetite Index reaching euphoric levels.
• Investors as a group now have record-high allocations to equities, while being underweight bonds and holding minimal levels of cash.
• Exchange-traded funds (ETFs) have enabled investors to overcome the resulting lower liquidity in certain market segments, but a proliferation of small deals may affect future liquidity.

Tail risks: Neutral

• Concerns over COVID have receded as the global vaccine rollout gathers pace. Instead, many investors are fretting about resurgent inflation and the risk of a further bond market sell-off.
• Loose monetary conditions have fueled a meteoric rise in the value of cryptocurrencies, non-fungible tokens, celebrity sneakers, and other “alternatives to fiat money.”

Bottom line on high-yield bonds

High-risk appetites have left investors with stretched positions and spreads offering little or no cushion in the event of sudden reversals. While current conditions may persist, investors should tread carefully, keeping an eye on both quality and duration.