The high yield market has performed poorly over recent months, led by a spike in the borrowing costs of energy companies, which has resulted in more defensive pricing of all sectors in the investment universe. However, now that implied cumulative default probabilities (based upon Moody’s data) exceed the worst recorded occurrence, we feel it is time to revisit the sector.
In terms of fundamental valuation metrics for the sector, the picture is mixed. For 2016 US default probabilities are expected to rise towards the long term average of 5.5 per cent, but these are likely to be concentrated in the energy sector. Within Europe and the UK, default rates are likely to be significantly lower given the much smaller number of energy issuers. Leverage ratios are a little better than the long run average across the high yield spectrum, interest cover has improved since 2008 and the recent widening of yield spread per unit of leverage makes the asset class more interesting.
Outside of energy, the market’s major fear has been the risk of weak growth in the sector. Our best guess is we shall see a moderate US expansion this year – not too weak that it will spark a wave of defaults, but not so strong as to encourage excessive borrowing.
We feel whilst the US Federal Reserve will retain a tightening bias, the risk of significant tightening of credit conditions is unlikely to materialise. This is because growth and inflation data are unlikely to be strong enough to warrant the type of hiking cycle anticipated earlier in the year which troubled fixed income investors.
Elsewhere, whilst European growth remains disappointing, the flip side of this is the increasingly activist stance from the European Central Bank – via keeping rates lower for even longer and its asset purchase programme – is likely to support European carry strategies in the months ahead. This view is underlined by the increasing number of European securities which now trade at a negative yield.
As the credit cycle matures, sector and individual issuer risk inevitably increases and a global, bottom-up approach to asset allocation in the high yield sector is increasingly justified.
The Kames High Yield Global Bond Fund offers a GBP hedged class which at end-January yielded 5.75 per cent with a modified duration of 3.75 years. Crudely put, this means that, even if yields rise by 125 basis points over a 12-month period, the fund will still outperform cash. The fund has a low (6 per cent) weighting to energy and offers a significant amount of regional and sectoral diversification. Those investors seeking even less interest rate exposure (typically between one and two years) and greater relative returns from pure credit selection might wish to consider the Schroder Strategic Credit Fund, which targets Libor plus 3 per cent.
Jonathan Cunliffe is chief Investment officer at Charles Stanley