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US high yield – Keep calm and carry on

Overview

  • The current benign macro environment should continue to reward carefully calibrated credit risk
  • Historically, long carry strategies tend to outperform in low volatility environments
  • Our lead indicators1 are consistent with default rates remaining contained for now

Search for yield

With the 10-year G7 government bond yielding less than 1%, positive inflation-adjusted returns look hard to come by in the higher quality corners of the fixed income complex.

A still benign inflation backdrop, a multi-decade bull run in interest rates and the lingering monetary policy hangover from the most serious recession (and financial crisis) in living memory are just some of the factors that explain these historically low yields. We are certainly expecting the backdrop to become a little less friendly for higher quality bonds. Central bankers are rightly becoming less lenient (particularly in the US) for a start.

However, with inflationary forces still in abeyance, we expect this normalisation to be glacial relative to past rate rising cycles. In such a context, PBOS Investment Division still sees investors being rewarded for taking carefully calibrated credit risks (Figure 1).

Carry - a time-tested strategy

Historically, long carry strategies – that is, being long a higher yielding asset while being short a similar low yielding asset – have generated consistent outperformance over time. These carry strategies have tended to outperform in benign market regimes like the one we still find ourselves in now. The US economy is enjoying robust growth, supported by buoyant consumer spending. Given the upbeat state of the ISM Manufacturing Index (our preferred lead indicator for the US business cycle), PBOS Investment Division expects growth momentum to persist into next year, leading to lower default risk for the dicier parts of the US credit market. US high yield debt looks attractive to us from a risk/reward perspective.

Spread compression

High yield spreads have tightened significantly this year, and as with much of the credit space, are now trading back in the range seen in the mid-2000s, with yields well below those levels. There are many reasons for this tightening, but the improvement in quality within the high yield segment, with higher-rated issuers making up an increasing proportion of issuance, should provide some reassurance.

Essentially, at least some of this move reflects fundamental changes in the high yield space. For now, we aren’t seeing any obvious red flags, such as signs of excessive leverage from US corporates, or increased issuance from the riskiest issuers.

Risks

We note that long carry strategies are vulnerable to sharp near-term drawdowns when wider market conditions turn. High yield bonds tend to exhibit a higher frequency of ‘fat-tail’ losses in their return distributions, despite having better risk-adjusted returns than equities over the long term. Hence, this particular strategy is only suitable for long-term investors with a high tolerance for drawdown risk. The other point to make is that this is a sub asset class where selection can reap significant dividends over passive access.

*ISM manufacturing and US 2 - 10 yield curve

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