High-yield bonds are corporate-issued bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. Payden & Rygel high yield portfolio managers Jordan Lopez and Nicholas Burns shared their outlook for the asset class and why investors should consider investing now.
The year is off to a great start for fixed income markets. What are your expectations for the rest of the year?
Jordan Lopez: It’s hard to not see more of the same at this point. The data continues to come in fairly strong. Inflation has been stickier than I think the Federal Reserve would like to see. Unemployment remains historically low, so for fixed income it’s hard to see anything other than a fairly hawkish Federal Reserve and strong fundamental macro data.
We don’t expect to see the same type of spike in rates that we saw last year, but rather staying range bound. Barring an exogenous shock, we don’t expect interest rates to rally at this point.
With Treasuries paying in the 4% range and investment grade credit paying over 5%, why would an investor take on any extra risk with high yield?
Jordan Lopez: The most obvious reason is for the incremental yield. The best predictor of long term returns in the high yield market is the starting yield. There’s a 0.95 correlation between starting yield and next five year annualized returns.
So if I’m an investor and I don’t think I can time the dips and the rallies perfectly, and I see that I’m getting 8.5%, 9% yields, and think that’s going to be my annualized return over the next five years, that’s a pretty attractive place to be for patient investors, especially given the strong fundamentals of the asset class.
Nicholas Burns: Eight-to-nine percent yields give you a lot of room to maneuver. In a bullish case, you are generating attractive yields in a relatively strong market environment. The data has been coming in better than expected and earnings for high yield issuers have surprised to the upside pretty persistently.
But even in a downside scenario, you’ve got a lot of cushion built in the event that macro volatility surprises to the downside. Additionally, the fundamentals of high-yield issuers in aggregate are so much better than they’ve been in the past – a lot of our issuers actually have the wherewithal to manage through a recessionary environment.
Even in the event that defaults end up surprising to the upside, we wouldn’t expect to see the kind of default environment that we experienced back in 2008 or 2002.
We hear a lot of talk about a recession that hasn’t really taken hold. If we do have a mild or serious recession, would that impact the high yield market?
Jordan Lopez: It certainly would. Anytime you have slower growth, it’s going to impact more leveraged companies, which is effectively what the high yield asset class is. If we do have a severe recession, we could certainly see a spike in the default rate. We just don’t see any indication of that at this point.
Assuming it’s a mild recession, we will see some of the weaker companies that have been propped up by easy money over the last several years need to restructure. But again, when we look at the breadth of the high yield asset class, we don’t see a large cohort of defaults in that asset class in a mild recession scenario.
You focus on the higher quality high yield debt and give up yield to not go down in the credit ratings. Why do you focus on higher quality bonds?
Jordan Lopez: We run our strategy very benchmark aware. We’ve learned that if you can beat the benchmark net of your fees, you are going to be one of the top performers in your peer group. So we are very focused on beating the benchmark, and part of that is taking a view on each significant position within the benchmark, whether we want to be overweight or underweight in those.
We bench ourselves to the BB/ B ratings segment because when we look at CCCs, we find that over the long run, CCCs don’t actually add to your total returns, but they do introduce a lot of volatility. We want to be in a position where we only own CCCs when we have conviction that it’s a good investment.
In other words, we don’t want to be in a position where we’re owning CCCs just because they’re in the benchmark. That’s why we’ve elected to bench ourselves against the BB/B benchmark and hence being structurally up in quality. However we do own CCCs in the portfolio. It typically ranges from 5% to 10%, and we do find opportunities there regularly. We are not afraid to invest in CCCs, we just don’t want to be beholden to the benchmark to do so.
Nicholas Burns: The next step of the process is to try and identify where relative value is. If your core investment universe is, call it, BB, single B rated issuers, then it’s our job to figure out where we’re getting paid in excess of fundamental risk. That’s obviously the most challenging part of the job.
But if you can do that in a way that’s consistent over time and where you’re building a portfolio where the aggregate level risks are balanced, then you can get comfortable taking issuer level risk and ultimately add value across cycles. Which is our objective – to have a strategy that adds value regardless of the market environment, regardless of whether it’s a strong market environment, a weak market environment, rising rates environment, et cetera.
Where are you placed in the duration spectrum?
Jordan Lopez: Given our process and being very focused on relative value and credit selection, we believe we can generate alpha without having to pull the duration lever. We’re typically neutral relative to the benchmark in terms of duration.
And rather than try to time movements in rates, which can be very difficult, we feel that we can neutralize that factor and generate alpha doing what we do best, which is the credit selection part. We don’t need to make duration bets, for lack of a better term. Typically duration is only around four years for the high yield asset class, which is why it was one of the better performing fixed income asset classes last year.
In terms of high yield issuance, give us an idea of the landscape. Was it stronger this year than last year?
Nicholas Burns: Last year we saw a dramatic pullback in issuance. Which makes sense – in a rising rate environment, issuing debt is just going to become less attractive than it had been in the lower rate environment.
What we had gotten used to in 2020 and 2021 with the Fed being very easy was a dramatic wave of debt issuance by high-yield issuers looking to refinance their capital structures at very low coupon rates, and then extending their maturities out to lock those coupon rates in for as long as they could.
So there were very dramatic issuance levels in 2020 and 2021, and then falling pretty dramatically last year. In part that’s because of that dynamic of simply the economics of issuing at higher coupon rates doesn’t make sense, but also in part because of how much refinancing had gotten done in 2020 and 2021, there simply wasn’t much need for refinancing deals to happen.
Another big source of new issue in our market is leveraged buyouts (LBOs), but with higher interest rates the math on LBOs just becomes more challenging to work. And we saw a fall in LBO issuance in 2022. Entering into 2023, those dynamics haven’t really changed much.
Obviously, rates are as high as they’ve been in this cycle, but you are starting to see a pickup of new issuance as issuers work through their existing maturity walls. It makes economic sense for them to start chipping away at existing debt by issuing opportunistically when the window is open to them and when coupons are manageable. Those deals are getting done.
In fact, May was the heaviest month for new issue that we’ve seen since January of last year. So effectively the heaviest new issue month that we’ve seen in this higher rate cycle, which tells us that investors are still putting money to work in viable capital structures. It’s also notable that even though May was the busiest month for new issue over the course of the last 18 months, the rate of new issue in May was well below what we saw in 2020 and 2021.
Jordan Lopez: There has been about $80 billion of issuance so far in 2023, which is well ahead of last year. But when you go back to 2021 when the markets were wide open , issuance was about $250 billion at this point in the year. So it is down very, very materially from where it was before the rise in yields.
Are there sectors that you favor and sectors that you are avoiding or are you evaluating on an issue by issue basis?
Jordan Lopez: It’s more the latter. We’re very aware of how we’re positioned sector wise relative to the benchmark. We certainly don’t want to have large bets on sectors, and our selection is definitely more issuer driven than it is sector driven. We’ll go anywhere where we find relative value.
And interestingly, right now we find ourselves overweight to some of the financial sectors because of the recent turmoil in regional banking – an overused term in investing is “the baby’s been thrown out with the bath water.”
So we find a lot of credits in some of the financial sectors, whether it be financial services or insurance that look relatively cheap to our universe. We still favor a lot of the energy credits. We look at the individual credits, and that’s really where the overweights and underweights are born.
Is there anything going on in the market that you find interesting or counterintuitive that we haven’t covered?
Jordan Lopez: There has been a lack of demand for bank loans this year and we’ve seen a lot of the refinance activity for loans done in the bond market. As a result, we’ve seen a very high percentage of issuance come senior secured in the bond market, which is unusual for bonds. Typically, bonds are unsecured and loans are secured.
But, as we’ve seen more and more secured issuance in the bond market, the overall composition of the bond market has become more secured. It’s up to about 30% secured. And the knock on effects of this are if we do get an increase in the default rate, more secured issuance means higher recovery rates, all else equal. I think this helps put somewhat of a floor on high yield bond prices the more senior secured issuance there is. That’s one of the trends we’re watching lately.
This information is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. The statements and opinions herein are current as of the date of this document and are subject to change without notice. Past performance is no guarantee of future results.