A version of this article was originally published in Wealth Manager on 5 January 2022.
Introduction
After a year characterised by economic recovery, 2022 is likely to pose more complex questions.
High yield bond investors will need to navigate a change in monetary policy direction, entrenched inflation and increasing pressures on many businesses. It is likely to be a year where returns are driven by idiosyncratic risks for individual bonds, rewarding judicious stock picking.
2021 was about recovery, as economic activity resumed following the pandemic. This led to strong performance from cyclical areas such as commodities, financials and some consumer-facing businesses.1
However, growth rates have peaked and inflation is picking up. The backdrop is more volatile and certain businesses may struggle to adapt. This is likely to drive a divergence in credit quality between the ‘haves’ and ‘have nots’, not least in terms of cash generation and pricing power.
At the same time, there has been record new issuance in high yield debt markets as businesses have sought to lock in lower borrowing costs and rebuild after Covid.
Issuance of EUR45.8 billion in the second quarter of 2021 represented the strongest quarter in history for European high yield markets.2 In theory, this should bring additional choice for high yield investors, but in many cases, the quality of new issuance has been worsening with weaker legal protections for investors.
Some flexibility will be needed to navigate this more complex backdrop, which will be nuanced in terms of the business models that perform well.
Bond managers need to be careful on where they take risk and keep a close eye on the quality of their holdings. Businesses will need strong pricing power, resilient cash flow, and a stable business model to thrive in a more volatile environment.
Opportunities Despite Inflation Risks
Inflation has become a key concern for investors of all hues. Inflation appears increasingly ‘sticky’ and is likely to last into 2022, in our view.
Rising labour costs in particular mean that inflation is unlikely to be transitory as was hoped initially. Supply chain problems do not appear to be easing materially and run across multiple sectors, from food retail to car manufacturing.
High yield markets have historically performed relatively well during periods of inflation.3 Stagflation would be a far greater concern, but with nominal growth running at 8-10%, it is an outside risk.
High yield is one of the few areas of fixed income that may still deliver a real return, ahead of inflation. With the spread component around 80-90% of the return, high yield bonds can also perform reasonably well if rates rise.
However, it is still important to invest with an awareness of inflation risks.
Companies with pricing power are in a far better position to navigate inflationary pressures. We believe this should be a strong theme in high yield strategies today. It would also influence geographic positioning. For instance, we see greater inflationary pressures in the US, while European companies are at an earlier point in the cycle and tend to have less leverage and more compelling valuations.
We are positive on the services, health-care and telecoms sectors, where rising costs can be passed on, while less so on the automotive sector and consumer discretionary companies.
Highly cyclical businesses look vulnerable in this environment, in our view. On the other hand, some financial names are benefiting from rising mortgage origination as well as hardening rates, while UK food retailers have the ability to pass on higher input prices.
The Risky Spots
The shifting environment has also led us to have a negative outlook on the lowestrated names in the US, such as CCC bonds, unless there is a powerful catalyst for improvement. We find better value in mid-tier rated bonds.
Asia and emerging markets may also be more difficult areas today. Indeed, fiscal and monetary policy tightening bought about a significant repricing in 2021.
It is important not to overstate the risks in high yield markets today. Default rates are still low and there are no worrying imbalances – the corporate sector is not overindebted, household balance sheets are also not stretched; only governments have very high debt. We expect interest rates to rise, with our expectation being that the Federal Reserve will hike in mid-2022.
Conclusion
We believe this remains a good climate for high yield bonds, particularly relative to other parts of the fixed income market, but fund managers need to tread a little more carefully and show flexibility. Most of all, they need to do their credit analysis. This is definitely an area where our attention will be focused in the year ahead.
1. Source: Bloomberg.
2. Source: Bank of America.
3. High yield represented by ICE BofA Global High Yield Index.
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