Chalk it up to human nature, but many investors tend to shy away from ostensibly riskier asset classes when market gyrations, currency fluctuations and interest-rate anxiety dominate the headlines. In other words, times like these.
Yet the same factors roiling markets and driving volatility in many asset classes are creating opportunities for active managers focused on seeking relative value across the global high yield spectrum, including high yield corporate bonds, senior secured loans and collateralized loan obligations, both in the U.S. and Europe.
Portfolio diversification, protection against rising interest rates, the potential to earn attractive risk-adjusted returns and low correlation to other asset classes are a few of the reasons financial advisers should be taking a closer look at global high yield.
Despite headwinds including declining oil and commodity prices and slowing growth in China, corporate fundamentals, particularly outside of the troubled energy and metals and mining sectors, continue to look stable. During the recent period of volatility, the global high yield market has benefitted from its growing diversity across both asset classes and geographies. In fact, through the third quarter, returns on European senior secured loans (+3.76%) outperformed all other major fixed income asset classes, and beat the S&P 500 by over 9%.
While risks must be monitored carefully and credit selection remains paramount, today's macroeconomic landscape is presenting some specific opportunities for active managers in global high yield markets.
Market volatility: Credit prices typically become decoupled from underlying fundamentals during periods of volatility, creating opportunities for active managers to find long-term value in credits with strong balance sheets and stable business models, where valuations have declined more than fundamentals warrant. Look no further than the energy sector, where some managers employing rigorous bottom-up credit analysis have been able to lock in value amid indiscriminate discounting.
Market volatility also can amplify the effect of technical factors that likely will impact U.S. and European high-yield markets differently and thus create short-term relative-value opportunities for managers investing in both. For example, changes in the flow of funds into and out of retail mutual funds and exchange-traded funds and the level of CLO issuance can result in loans from the same company trading at materially different valuations in the U.S. and Europe. For a nimble active manager, this can equal opportunity.
Interest rates: Rising interest rates are generally considered to have a negative impact on bonds but high yield bonds and senior secured loans don't always fit that stereotype.
LESS RATE SENSITIVE
High yield bonds, because they are more of a play on credit risk, generally have been less rate sensitive than some other asset classes. Loans, which have a floating-rate coupon, are one of the few asset classes that can actually benefit from a rising-rate environment. With balance sheets outside of the energy and metals & mining sectors in a relatively strong position, a rate increase of 25 to 50 basis points is not expected to alter the fundamental picture.
In a broader sense, the prospect of a rate hike in the U.S. while quantitative easing continues in Europe clearly highlights how diversifying exposure across different central banks and rate environments can reduce portfolio sensitivity to changes in any one monetary regime.
Currency fluctuations: Similar relative-value opportunities exist as a result of fluctuations in the value of currencies between the U.S. and Europe. An active manager can identify U.S. dollar- and euro-denominated securities issued by the same company with the same terms that are trading at different prices based on the currency in which they were issued.
This raises an important point: Many strategies that are marketed as “global” in nature actually just include the U.S.-dollar denominated credits of European companies. A more effective global high yield strategy is currency-agnostic: Invest across geographies to find the best relative values, then hedge the currency risk.
Investing in global high yield should be viewed as a strategic allocation. In addition to delivering historically attractive returns relative to other asset classes, a portfolio of U.S. and European high yield bonds and senior secured loans (and structured credit investments backed by these loans) can offer diversification benefits due to their low correlations with other asset classes and the effect of spreading exposure across multiple geographies. In addition, the larger universe of available credits gives managers greater flexibility to shift between high-yield asset classes and regions as opportunities arise and fade.
Investors shouldn't let volatility alone dissuade them from considering global high yield. Out of volatility can come opportunity, and while prices may ebb and flow, investors can benefit from a long-term approach based on the conviction that over time, fundamentals and judicious credit selection will drive returns in global high yield markets.
Michael Freno is head of U.S. high yield investments and Zak Summerscale is chief investment officer of European High Yield for Babson Capital Management, a global asset management firm.