11 Dec 2018
2018 has so far been a testing time for the high yield bond market. What has been happening and what does this mean for investors?
After the strong returns of 2016 and 2017, this year has so far been a more testing time for the high yield bond market. What has been happening and what does this mean for investors in the asset class?
I think the first point to highlight is that this has been a difficult period for fixed income assets in general and not just high yield. As at 30 October 2018, global high yield bond returns are down 0.4% year-to-date. Global investment grade by comparison is down 2.3% over the same period. The higher level of income inherent in high yield and its lower duration have both supported total returns and helped contribute towards its outperformance.1
A borrower’s market
At the start of the year, the demand for income and low yields meant that some issuers were able to price new bonds very aggressively, both in respect of the coupons being offered and the terms at which these bonds were issued - it was very much a ‘borrower’s market’. The headwinds that the bond market has since faced (tightening liquidity, Italian elections, trade wars, emerging market volatility) have helped to bring some value back into the market and have enabled investors to push back on some of the more aggressive deals.
Nonetheless, there are signs that we are in the latter stages of the current cycle. Corporate financial leverage is ticking up, quantitative easing is ending, and although there has been some push-back on more aggressive financings, the market is still a long way from being what I would consider creditor-friendly.
Security selection is key
One further important trend within high yield markets this year has been the increase in the dispersion of returns. Analysis by Morgan Stanley of the price return (i.e. excluding coupons) of the high yield bond market in 2017, showed that 60% of the market provided a positive price return and 40% a negative return. This year, just 10% of the market has provided a positive return with 90% providing a negative return (see figure 1). The implications of this are, I think, clear. First, simply allocating to the sector to harvest beta is likely to be a costly strategy: and secondly, this highlights the ongoing importance of security selection within high yield bond markets.
1ICE BofAML Global High Yield Index and ICE BofAML Global Corporate Index (local currency total returns).
Figure 1. Security selection is increasingly important
Dispersion and contribution returns
Source: Morgan Stanley Research, Markit iBoxx, 26 October 2018.
Security selection underpins my investment approach. I will only invest in a bond or issuer when I think I am being adequately rewarded for doing so. Using this approach, I have built the fund around three key themes.
First, the core of the Invesco High Yield Fund (UK) is focused on what I think are good quality companies that have some leverage. Typically, these are companies that are dominant within their industry or sector. Companies that have predictable cash flows and that are generally, but not always, rated at the higher quality end of the high yield spectrum.
Second, I have a large allocation to subordinated financials. This is a long-held allocation that benefits from the ongoing balance sheet repair of the banks and economic recovery. Many of these bonds are issued by investment grade issuers, but because of the subordination risk are rated high yield and carry an additional yield to compensate. The overall level of risk within this position has fallen in the last 18 months. Many of the bonds are now on short call dates (12-18 months) and it is our expectation that most of the banks will redeem the paper at its first call date.
The final theme is more speculative holdings. Such bonds represent a smaller part of the fund (I typically hold around eight to ten of these type of positions). They are held with the intention of giving the fund some additional yield and total return from capital gains.
Core holdings
Tesco is a good example of one of the fund’s core holdings. The UK grocer is a former investment grade issuer that was downgraded to high yield in 2015 – a so-called ‘fallen angel’. The company is asset rich as a result of its extensive property portfolio. Furthermore, management at the grocer have been explicit about their intention to return the company to investment grade status. Reductions in Tesco’s pension deficit, bond buybacks (as recently as October) and a decrease in the company’s lease commitments through the repurchase of some UK stores have all helped to materially reduce the company’s net debt. Meanwhile, its operating performance has strengthened. In recognition of this, Fitch has returned Tesco to investment grade and Moody’s has changed its outlook on the company to positive, stating that it expects further improvements in the company’s credit metrics. These positive developments are reflected in the year-to-date performance of the long-dated bond shown in figure 2. The key risk highlighted by Moody's is the ongoing challenge from discount retailers and the potential impact of the Asda and Sainsbury's merger.
Figure 2. Price performance of the Tesco 5.8% 2040 bond
Source: Bloomberg as at 30 October 2018.
Finding opportunities…
…in retail
Changing consumer habits and uncertainty surrounding Brexit are clearly affecting the high street; however, the negative sentiment toward the retail sector is creating some interesting opportunities. Matalan is a case in point and an example of one of the fund’s more speculative positions. In my view, Matalan is in the best shape it has been for years. The issues with its distribution centre that caused problems in 2015/16 have now been resolved. This year, during what has been a difficult period for UK retailers, Matalan has shown an increase in year-on-year sales. There are also indications that Matalan has been increasing its focus on higher quality merchandise where it can achieve better margins. This follows on from the refinancing of its outstanding debt in January, extending the maturity of the bonds in issue. In my view, the discount clothing retailer’s business model is well suited to today’s landscape, but the bonds are being weighed down by the negative sentiment surrounding the sector. As at 30 October, the 2023 first lien bond yielded 9.5% while its 2024 second lien bond yielded 12.7%.
…in energy
Elsewhere, a part of the market where I am finding opportunities is energy. A company that I have held in this sector for some time is EnQuest. Again, this is more of a speculative position, although it is perhaps less so now than when the position was first added. EnQuest is an oil production company currently developing the Kraken oil field in the North Sea. Kraken is one of the largest North Sea developments in recent years and is estimated to hold 137 million barrels of oil. The development has required considerable capital outlay and as a result EnQuest currently has higher net debt than most of its peers. The capital-intensive phase of the development is, however, now ending, and EnQuest is ramping up production. Latest figures show it is nearing its target of producing 60,000 barrels of oil a day. This should help improve cash flow and enable the company to start reducing its debt. In recognition of this, Moody’s has recently upgraded the company from CCC+ to B, while noting that a further upgrade is likely if production increases above 60,000 barrels a day - it is currently between 50,000 and 58,000. These positive developments have been reflected in the price; year-to-date to the 30 September 2018 EnQuest is the biggest contributor to fund performance (figure 3).
Figure 3. Price performance of the EnQuest 7.0% 2022 bond
Source Bloomberg, as at 30 October 2018.
Figure 4 highlights how avoiding weaker bonds is just as important in delivering the funds’ return objective as picking bonds that outperform.
A good example of a bond that has come under pressure is French retailer Casino. I have for some time had concerns about the company’s corporate governance and lack of transparency. In my view the yields on offer have not adequately compensated for the potential uncertainties I find when I start looking at the company. For example, a Casino bond maturing in 2023 was, until early August 2018, priced above par with a yield of little more than 3%. Even today, this bond yields barely more than 5%, which to my mind is not sufficient compensation for the factors outlined above. These uncertainties and the poor balance of risk and reward has meant I have not had any exposure to Casino or its parent company, Rallye. I have preferred to seek out opportunities elsewhere.
So far this has proved to have been the right decision as the market has become increasingly concerned about the group’s cash flow, its liquidity and the maturity profile of its debt. Over the next 2 years the highly leveraged parent company, Rallye (through which Casino CEO Jean-Charles Naouri controls Casino) has around €1bn of debt due that it needs to refinance. It has recently been able to raise €500m through bank loans maturing in 2020 and by selling its Courir sports brand to private equity firm Equistone Partners Europe for €283m. Meanwhile, Casino has sold a minority stake in solar energy subsidiary, GreenYellow, and agreed a sale and leaseback programme for property connected to its Monoprix supermarket arm. These measures help alleviate some of the immediate funding pressure. However, there remain concerns about the company’s longer-term ability to refinance and how doing so will affect unsecured bond holders with longer maturity bonds.
Figure 4. Price performance of the Rallye and Casino bonds
Source: Bloomberg, as at 30 October 2018.
This year has certainly provided a bigger test for us as high yield investors and the sector faces plenty of challenges in the months ahead. But, by focusing on security selection and making sure we do the due diligence, we aim to concentrate as much of the fund on those bonds that can outperform and reduce our exposure to those that are likely to face problems.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
The securities that the Invesco High Yield Fund (UK) invests in may not always make interest and other payments nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity for the securities in which the fund invests, may mean that the fund may not be able to sell those securities at their true value.
These risks increase where the fund invests in high yield or lower credit quality bonds and where we use derivatives.
The fund has the ability to make use of financial derivatives (complex instruments) which may result in the fund being leveraged and can result in large fluctuations in the value of the fund. Leverage on certain types of transactions including derivatives may impair the fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the fund being exposed to a greater loss than the initial investment.
The fund may be exposed to counterparty risk should an entity with which the fund does business become insolvent resulting in financial loss.
The fund may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
Changes in interest rates will result in fluctuations in the value of the fund.
Important information
This article is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.