326. High yield bonds: risks and rewards in today’s market

15 August 2024 (pre-recorded 13 August 2024)

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[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we’re diving into the intricacies of the high yield bond market, exploring its growth, current valuations, and the opportunities it presents in today’s economic climate. I’m Staci West and today I’m joined by Mark Benbow, co-manager of the Aegon High Yield Bond fund. Mark, thanks for joining me today.

Mark Benbow (MB): Thank you for having me.

[INTERVIEW]

SW: Now, the high yield bond market looks particularly attractive at the moment, so maybe just set the scene a little bit for our listeners. Give us your view on the asset class as we sit today. What’s been happening?

MB: Yeah, sure. So for those listeners that don’t know much about the high yield asset class it was kind of born in the 1980s. And it got this, it started off with this term “junk bond investing” and it’s never been able to kind of quite shake that term. But the high yield asset class has actually become pretty big in size. It’s become pretty high quality in size as well. And it’s really kind of exploded in the last kinda 15 years.

So it started off in the US and then around the late nineties it started off in Europe. So today the asset class is about $2.2 trillion in size. And that $2.2 trillion is spread across about 1,500 companies and about 3,500 bonds. So that’s our kind of investment universe.

And then the asset class today you can kinda look at it through two ways, like the bulls look at the asset class through the all in yields and all in yields are great. The yields of the asset class is about 7.5% to 8%.

The bears look at it on spread terms and say, oh, but the excess spread you get over and above government bonds isn’t a huge amount because obviously you think where base rates are, where interest rates are right now, they’re kind of mid-single digits. So actually the incremental payment you get for owning a high yield company or a sub investment grade company isn’t amazing. So there’s two different ways to kinda look at the asset class and there’s different people look at it through different ways.

But the asset class as a whole has just grown a lot. And it’s very big and now actually you just have very well established companies in the asset class and companies that want to be in the asset class. So if you think about in the UK we have companies like say Virgin Media, we’ve got Center Parcs, David Lloyds, PureGym. A lot of banks have high yield rated bonds, Lloyds Banking Group, Barclay’s Bank. In the US you’ve got companies like Uber or a lot of the airlines, a lot of the auto companies, Ford Motor Credit was just in our index, it just left and went back up to investment grade now.

So while you do have lots of private companies and some of those private companies are very levered, they’re owned by private equity companies. There’s also lots of public companies as well that are just really well known blue chip companies that you’ll have heard of in your everyday lives. So yeah, it’s an interesting asset class and it’s definitely one that’s become a lot higher quality in terms of the participants in it as it’s grown in size over the last kind of 10 to 15 years.

SW: And how do these high yield companies hold up in this environment? Are you seeing signs of weakness with slowing economic growth and high rates?

MB: Yeah, so there’s kind of two ways to answer the question. There’s the companies themselves and then there’s the bonds themselves. And I think there’s this kinda misconception that, you know, good companies make good bond investments and bad companies make bad bond investments. And actually the two are often not as closely correlated as you might like.

So for example, let’s use an extremist scenario. If you’d bought Google bonds in 2020 and you had a crystal ball and you knew that Google was going double, its earnings and the share price was gonna be up hundreds of percent and then you were to buy the bonds, you’ll lost half your money on the bonds because the bonds are really just causing interest rates. And the same way that you know, you fast forward to a bad company, something like Credit Suisse, obviously effectively went bust. Again, depending on where you sat within the capital structure, you could have either lost all your money or actually it was one of the best-performing bonds in the market last year because it became part of UBS, which was investment grade high rated.

So when you ask about how is the high yield market holding up, there’s kind of two different ways to answer that question.

So from a bond price perspective one of the key attributes of the high yield market is it’s quite a short duration asset class. And that just means that the average life of the bond is quite short. And as you can understand, if it’s a higher, you know, risky company, higher level company, it’s riskier. People don’t want to lend to that company for long periods of time. They’d rather lend to them for shorter periods of time. So as a result, the asset class is lower in duration, but that gives you the benefit that when bonds are closer to maturity, they actually don’t sell off as much. So the asset class is holding up really well right now. So even though we had that little kind of mini wobble a few weeks ago we’re kind of back to unchanged from where we were and the market never really dropped, drew down all that much anyway. It was maybe off half a point and it just kinda snapped back again.

The companies themselves, it’s kind of a mixed picture. There’s companies that are from a top line perspective doing very well in this environment and are starting to see a little bit of slow down. But then there’s also companies that are doing fantastically well but have borrowed huge amounts of money.

And then you know it yourself, right? If you borrow huge amounts of money and you’re used to really cheap rates of interest, suddenly when those bonds come around to refinancing again you can be doing really well as a business but suddenly you’re like, hey, like I’ve just swapped my 4% coupon for a 10% coupon. And obviously that’s really painful for the company, great for the bond holder because obviously you’re getting paid a lot more now. But you just have to be careful that the company doesn’t have too much debt.

So to kinda summarise it, the market as a whole from the bond side is holding up and then from the earnings side it’s kinda mixed. There’s areas that are doing fine and just, you know, I don’t really see any slow down at all and still posting really strong kinda like for like growth and there’s others that are just starting to kind of creak around the edges a little bit.

SW: You mentioned the slight wobble there, which we are recording on the 13th of August, so not too long ago. The volatility that we saw in early August, was there any impact to high yield?

MB: Yeah, I mean it’s kind of blink and you missed it. Like there wasn’t really much, it was like a one day dip. And even that dip was pretty hard to buy if you kinda knew things were gonna snap back. I mean if you look at the lowest rated part of the asset class, so CCC, so these are the most risky companies within all of high yield. The ones that have the most debt on their balance sheet. They were down like one and a quarter points maybe. And now they’re back to unchanged.

And then the kind of higher quality part of the asset class was off, yeah, maybe half a point. And again, we’re kind of effectively back to where we were again. So it wasn’t really, it never really transpired – the equity markets are actually the same, like I think the S&P actually yesterday recovered eventually back its losses again. So we’re kind of, yeah, like everyone was kind of, yeah, surprised at how quickly things snapped back. Like it didn’t really transpire into this, you know, greater sell off. And much like the equity market, the high yield market was pretty similar.

SW: Are you expecting more volatility ahead or another wobble as you said in the later stages of this year?

MB: Yeah, I mean for, it feels like for a few years now we’ve been talking about like increased volatility. And the reason we think there’s gonna be increased volatility is if you think about like what central banks have done like over the last 15 years, they’ve like suppressed all this volatility because you’ve had these bond buying programs issued at central banks, and what’s meant to happen is markets are meant to be reasonably efficient.

So if you think about the market as like a table and there’s all the market participants sitting around the table and then as news flow comes out – positive or negative – like people say, oh, like this is good news, I think it’s worth more or it’s bad news, I think it’s worth less. But then you’ve had this like big guy who’s got more money than everyone else at the top of the table – the central banks – that regardless of the news and the market, just keep buying it. And they don’t care. They’re just like, they’re indiscriminate. They’ve announced the bond buying program and they’re gonna buy any price, whatever happens. And as a result you kinda have this artificial suppression of yields and obviously we had this crazy environment where yields went negative for European government bonds and Japanese government bonds as well. And then you think well, like zero’s not the floor anymore. So a negative number is the floor and then things get even more negative. And all that is because you’ve just got an irrational buyer at the top of the table who will just buy any price regardless of the information.

We’ve obviously entered into a period now largely caused by higher interest rates where central banks are starting to step away a little bit and obviously they’ve been raising interest rates, they’ve been stepping away from their bond buying program and you’d like to think as that buyer starts to, you know, downsize himself and stops buying as much and maybe even steps away from the table, that actually, news flow will start to impact bond prices more.

Now volatility is just another way to talk about difference in opinion. Volatility is the measure of how much something moves in price and obviously the greater opinion there is of something, the more volatility there’ll be. So I think hopefully we’re gonna enter into a market where I guess active managers can, I guess add more value because they can finally say, hey, like this thing should be higher in price or this thing should be lower in price. And you’re gonna get that kinda increased dispersion between the kinda haves and have nots.

So yeah, hopefully this time we are going to see volatility. I don’t think it’s something to be feared, I think it’s something we should look forward to. But yeah, like hopefully going forward we’re going to see a greater dispersion of market and actually I don’t think it’s healthy really over the last decade, if you’re really risky, you should get paid for that as a bond investor.

And so now there’s lots of companies now that are having to come to market and the rates of interest that are being charged on the debt they’re borrowing is really high and that’s the way it should be. And there’ll be companies that can’t survive and they have to restructure their balance sheets and there’ll be other companies that kind of, you know, survive and the bond holders get paid really well through that process. But I think all of it should hopefully be as a result of increased volatility from central banks no longer, you know, artificially suppressing volatility in the market.

SW: And then maybe just quickly, what kind of valuations are you seeing at the moment in high yield?

MB: Yeah, so we kinda touched on this point at the start. So if you take the long term yield of the asset class and then you see the long term spread of the asset class and there’s two different ways to kind of, it’s just two different lenses to kind of value the asset class.

On the spread side of the argument spreads are somewhere near all time tights. So there’s not a compelling spread argument to make. And as a high yield bond manager, I can’t sit here and pretend that all in spreads are attractive when everyone can see clearly, you know, just using history as a guide, they’re clearly not.

The way we’ve been trying to market the fund is on an all in yield basis where actually we are somewhere near the wides or the highs and all in yield. And our view is that actually it’s yield that pays you. It’s not spread that pays you.

If you go back a few years, we had much wider spreads but much lower yields. Now obviously it’s your yield that’s gonna equal your return if the bond obviously survive, presumably doesn’t default, you know, the starting yield is a really good guide to your future return. And that works really well in a bond investment. It doesn’t work well in equity investment because obviously a bond’s issued at par, it’s uncertain in terms of how it’s gonna move around, sometimes it’ll trade above par, sometimes it’ll trade below par, but it’s going to mature at par so you know how much money you’re gonna make if you hold that thing to maturity.

Obviously it doesn’t work for an equity because equity’s never mature, right? You could buy the S&P 500 and a 2% dividend yield, but it doesn’t mean you’re gonna make 2% yield. Whereas if you buy a five year bond with an 8% yield and you hold it to maturity, you’re gonna make 8% annualised over that holding period.

So I think, you know, our view is that spreads should be wider. You should get a spread pickup. We should be somewhere near the long-term averages in spread, but you probably don’t get that widening and spread when you have base rates so high.And so I think our view is that interest rates fall, spreads widen, you might get similar or lower yield from there depending on, you know, if it’s one for one or not. But ultimately something we’ll often ask our clients is, would you rather own the asset class if spreads were wider but yields were lower? Now it might make you feel better having wider spreads, but it won’t led to better returns if you’ve got lower yields.

And so that’s kinda the way we’re pushing the argument that the asset class right now and the argument we make in valuations, which is, hey, like we can’t sit here and say spreads are attractive, but that doesn’t mean you can’t make good money on the asset class when you’ve got all in yield. Our fund yields about 8% right now, you know, the asset class yields about 7.5%, there’s money to be made. Even though the spreads aren’t optically all that interesting. So I still think there is an interesting valuation argument. I just think you have to look at it through a different lens than simply spreads.

SW: And how does that translate to this portfolio specifically? Where are you finding the best opportunities?

MB: Yeah, so there’s a number of different ways to answer that question. There’s loads of ways to slice and dice your portfolio and we can go down any one of these kinda rabbit holes. So the most obvious one is people talk about regions and then talk about sectors and then talk about ratings.

Another way to think about it is like income and capital. And you can make money from two ways on a bond. Obviously you make money from the coupons that’s obviously your income or you make money from capital appreciation.

Now we are much more in the camp of income generation because we just don’t think given where spreads are, there’s that much capital upside. So we think all your returns are gonna come from income and probably not a huge amount from capital.

So right now if you think about the broad markets average coupon and our average coupon the broad market has about a 5.5% coupon and our average coupon is about 8%. So we are much more income focused in our portfolio than capital focused. And the flip side to that is our average cash price is a bit par of our portfolio. So the average bond has a price above par, whereas the market’s about 93, so actually the market’s got more capital upside, whereas we’ve got greater income. So that’s kind of one of the ways we’re playing the portfolio right now is playing more for income plays then capital plays and as in when spreads will widen eventually they always do, we’ll shift the portfolio more from an income play to capital play once there’s more capital upside to play for. So that’s kinda one way we’re kinda setting up the portfolio.

The other way we’re setting up the portfolio is we’re playing the front end of curves. We’re in this kinda weird environment where you actually get paid more at the front end than you do at the long end. Now historically, what would be the case of a company would come to you and you say, hey, we’re gonna issue bonds and we’re gonna issue a three year bond, a five year bond, and a 10 year bond. And obviously given the uncertainty of what’s gonna happen with time, you want to be paid more on the 10 year bond than you do the three year bond because who’s to say what’s gonna happen over the next 10 years. Right now because yield curves are inverted – and that’s just because we’re pricing interest rate cuts – you actually get paid more in the three year bond than you do in the five year or the 10 year bond. So right now we’re actually playing much more the front end of credit curves just because it pays you more.

Now you can make more on capital at the back end of yield curves if, you know yields fall and the back end’s gonna rally in price, the front end’s not gonna rally quite so much. But again, because we think spreads are quite tight we just don’t think there’s much rally to play for at the long end. So we’re playing the front end of curves just trying to get as much income as we can in the portfolio as well. And then the front end of the curve also protects you in a sell off because a bond that’s got one year to mature is going to sell off less than a bond that’s got five or 10 years to maturity. So you’ve got this kind of portfolio now or this market makeup where you can actually de-risk your portfolio but get paid to do it. Usually you have to give up some return to de-risk your portfolio, but right now you get paid more to de-risk your portfolio.

And then from a kinda regional and sector perspective we much more prefer Europe and the UK than we do the US. That’s not necessarily because of fundamentals, that’s just because the all in spreads are far greater in the UK and in Europe versus the US it’s more kinda a relative value argument when it comes to the bond side. The UK used to actually trade inside the market and then since Brexit, everyone’s hated any sterling denominated debt. Nobody likes to lend to UK companies. So that part of the market’s a lot cheaper now.

And then in terms of sectors we really like the consumer the consumer’s done really well and it’s the consumer’s still spending, we’ve had that trade on for quite a few years now. Our view is this, and it’s a pretty simple one, which is as long as the unemployment rates stay low, as long as people stay employed, they keep spending. And then the moment you lose your job, your spending habits actually change very quickly. Suddenly you stop, you know, spending all that discretionary income. People don’t generally like saving. So I think as long as the workforce stays employed, they’ll just keep spending on those discretionary sectors. And then the moment we see that start to uptick, then we’ll hopefully try and get ahead of it.

So we like the consumer, we like the banking space as well. The banking space is just doing really well right now. And part of that reason just improving the interest margins, so you’ll know yourself that your current account rate is probably not going up like a rocket, but your mortgage rate has. And so banks obviously make a margin between the two of them. And actually those net interest margins have been really expanding quite nicely. So banks are actually in a really good place and making lots of money for a change.

So hopefully gives you a flavour some of the, kind of the bets and some of the themes that we’ve got in our portfolio right now.

SW: I just wanted to finish with where this fund and high yield fits into an investor’s portfolio today.

MB: Yeah, sure. High yield often gets kind of forgotten about. It’s kinda this hybrid between equities and say traditional fixed income, so more like govies or investment grade and equities that kinda sits between the two. And people move between them when they’re nervous and wanna be risk off, they move their money out of equities into say investment grade and when they’re bullish, they move their money out of investment grade into equities and high yield gets forgotten about. But actually high yield generally gives you all the return of equity with a fraction of the volatility. And we’ve touched on why that volatility is a fraction just because bonds mature. And if you’ve got a bond maturing in the next one or two years, it can’t really sell off all that hard so long as the business is doing fine.

So I think high yield gives you a way to do a number of things. If you’re looking to de-risk your equity portfolio without necessarily giving up the return, you can move from equities into high yield and then what you’re doing is you’re moving from an asset class in equities, which is capital based, to an asset class, which is income based. So slightly different way that you generate those returns. About 85% of your return of the long term and high yield is from coupons or income, whereas almost all of your return in equities is from capital appreciation.

So if you’re looking to de-risk your portfolio you can do that. Equally if you’re looking to just increase the overall yield in your fixed income portion of your portfolio, you can clearly move from investment grade to high yield.

In both of these, whether you’re risking up or risking down, in both trades, you’re removing interest rate risk from your portfolio. And that was I think something the market learned quite quickly in 2022 is when interest rates rise, actually equities and fixed income are both the same trade. They both went down in tandem and actually they didn’t have this inverse relationship that people thought they should have. High yield obviously has a far less interest rate sensitivity. Now you you may think that’s a good thing, you may think that’s a bad thing. But if you’re looking at a balanced portfolio, then actually having both investment grade and equities might be at two ends of the risk spectrum from a credit perspective, but they’re actually at the same end of the spectrum from an interest rate perspective or duration perspective.

So again, if you’re looking just to offer more diversification into your portfolio, then actually de-risking into high yield or risking up into high yield removes a lot of that interest rate risk that is actually embedded in lots of different asset classes.

SW: Well Mark, that was fascinating and a great overview of high yield at the moment, so thank you for joining me today.

MB: You’re welcome. Thanks for having me on.

SW: The Aegon High Yield Bond fund differentiates itself from its peers through its high conviction and flexible approach, while also having a depth of experience on the team. The strategy’s flexibility allows the team to operate nimbly and exploit any market opportunities and inefficiencies as we’ve discussed today. To learn more about the Aegon High Yield Bond fund please visit fundcalibre.com