207. Why now is the time to be selective and different in the high yield bond space

Man GLG fund manager Mike Scott explains why credit spreads* are the major driver of returns in the high yield bond market and the importance of not only being selective, but also different, in choosing companies amid a weaker economic backdrop. He also highlights the role of cash flows in this environment and the focus on targeting businesses with recession proofing characteristics over a number of cyclical names. Mike also addresses the role of inflation in the high yield bond space and the performance of the US energy sector.

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What’s covered in this episode:

  • Why credit spreads are the major driver of returns for high yield bonds
  • The importance of the underlying credit quality of a business in this environment
  • The need to focus on cash flows, particularly in uncertain times
  • The robust state of the US energy market compared to recent history
  • Targeting recession proof businesses over cyclical credits and the importance of being selective in this environment
  • Businesses that can flourish or flounder in an inflationary backdrop

*Credit spread refers to the difference in yield between a government and corporate bond of the same maturity. 

18 August 2022 (pre-recorded 10 August 2022)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION] 

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re focusing on the high yield bond market and how inflation and the threat of recession alter the opportunities for investors. 

Chris Salih (CS): I’m Chris Salih and today we joined by Mike Scott fund manager at Man GLG. Thank you for joining us today, Mike.

Mike Scott (MS): Good afternoon. Thank you. 

[INTERVIEW]

CS: Lots of investors have been pushed into high yield because of super low interest rates and that’s sort of led to very little income from government and corporate bonds, but this is changing now and what essentially is the attractive for high yield bonds in the market at the moment?

MS: That’s a very good question. And I think it’s certainly the past decades you are right. Yields in the market were low on a historical basis across government bonds and credit. And much of this was driven by disinflation trends and very doable monetary policy from the central banks. 

Now, today, we see this rather different. Inflation has obviously come, has reared its head, and central banks are looking to counteract that by raising interest rates. And that has seen yields in the market across fixed income rise. So actually, yield all the return potentially asset class has increased. So that’s first foremost. 

But most importantly I would say is understanding the credit fundamentals themselves of the businesses, because there’s two aspects to the return within high yield is both the underlying government bond and the credit spread. And it’s really the credit spread, which is the major driver of returns through time. 

Actually, if you were to look at the yield of a high yield bond, typically 80% to 90% of the return potential is from the credit spread as opposed to the government bond yield. So therefore you know, what is changing now? I mean, clearly we’re in a higher inflation environment, but also potentially weak growth is back. This has seen spreads rise in aggregate. Now, I would say that in this environment really investors should really pay attention to is the underlying credit quality of businesses and the ability of those businesses to generate cash flow in this environment will really differentiate returns for investors.

CS: The high yield market is usually synonymous with the US energy market. Could you maybe go into why that’s the case and with the price of oil being so high, does this mean the sector is in much better shape on this occasion?

MS: Certainly it has exposure to the to the oil related corporates in the asset class. I mean, typically as you look at the asset class today about 15% of the market is US share oil and gas producers that has meant that this segment of the market has a quite high degree of sensitivity to obviously hydrocarbon prices, whether that’s gas or oil. And certainly over the past decade, we’ve seen significant swings with those prices and that has brought different credit backdrops for this segment of the market. 

Now, today there’s been significant supply side issues with respect to oil and also the supply of gas not least inflamed by the tensions and war in Ukraine. The flip side of this is that oil and gas prices remain elevated. And this means that these particular segments of the market are clearly able to generate stronger cashflow than in a lower oil and gas price environment. 

As credit investing goes, it’s really about cash flow and the ability of companies to generate cash. And in the current environment US energy corporates are generating a high degree of cash flow. And that, in terms of the question, certainly sees that these credits are in better shape than say where they were during the COVID period or indeed prior to that in sort of 2015.

CS: If we enter a recessionary environment, how is the high yield market like to react? And what’s the case for holding high yield in this type of environment?

MS: Well, I think there’s you know, a very important element is of investing in high yield is that you are investing in businesses and the cash flows of those businesses. So those businesses generate cash that’s really what is used to pay the coupons and effectively refinance the debt. So in a recessionary environment, certainly cash flows of businesses typically decline, particularly for the more cyclically orientated corporates. And this means that the risk of all the credit risk of these businesses rises and typically during these periods, you see the expectations of corporate distress or indeed defaults rise and this leads to higher risk premiums in the market or what we would call the spread of the market. So as we go through a low growth backdrop, you should expect spreads in the market to rise in aggregate. 

Now as we look at the market today, clearly there are some concerns about a weaker or an unfolding, weaker growth picture, and indeed, the spreads are have widened during this year and potentially have room to widen further. And if growth continues to weaken that said spreads are now trading at their median spread level over the market’s history. So some degree the market is already pricing a weaker growth backdrop. 

Really what’s important is to really focus on those businesses that can generate cash flow and stability of that   through a weaker demand backdrop as ultimately, that is what is paying returns on your bonds.

And really what I think will differentiate good returns in the asset class will be focusing on you know more recession proof businesses that are able to weather a weak growth backdrop versus more cyclical credits, which the jury is still out as to how these credits may look in a recessionary backdrop. So what I would say is that this is a period to be selective, it’s a period to really differentiate with respect to credit quality and businesses that are able to generate cash flow in a weak demand environment. And that is certainly what you’d expect to see if we enter a recessionary environment.

CS: You mentioned, if we enter a recession environment, we’re certainly in an inflationary environment at the moment, how does inflation affect high yield bonds and does high yield help mitigate the impact to a degree?

MS: Again, very, very interesting question. It does in a broad sense. Now why is that the case? Because nominal growth pays and generates nominal cash flows, which pays nominal coupons. So obviously with a higher nominal growth backdrop i.e. with a higher inflationary backdrop arguably cash flows should be higher. Now it’s not quite as simple as that. Because ultimately when you look at companies, you really need to understand, whether a company has pricing power, for instance, or the ability to pass on cost pressures, which are certainly part and parcel during inflation periods, so not all companies are created equal by any stretch. 

So yes, for those businesses that have strong pricing power can pass on cost pressures easily, or have escalator clauses within their contracts or are in fairly monopolistic industry structures, I would say have a very good ability to pass on those cost pressures. For instance, pharmaceutical companies, or potentially consumer staple companies, I would sort of put into that category. Whilst businesses that are more cyclically exposed with strong cost pressures resulting from high higher input costs or labor intensity, i.e. having to employ lots of workers I can see struggling in a higher inflation backdrop. 

So it really is very critical not just to think about the inflation backdrop, but also to think about what businesses as you can flourish or potentially flounder from that inflation backdrop.

CS: That’s great, Mike, thank you very much for joining us today.

SW: To learn more about high yield bonds and start your research on the Elite Rated Man GLG funds please visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.

Please remember, we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.

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