The high yield universe is shrinking, political risk rising and innovation shifting opportunities but as ever forecasting complex systems – such as financial markets and the global economy – is inherently difficult, April LaRusse, Insight Investment's head of fixed income investment specialists, notes.
In asking what weather forecasters and financial analysts have in common, she points to research showing that while confidence in financial analysts was 80% versus just 30% in weather forecasters, the latter is often far more accurate in its predictions (70% versus 20% in analysts).2
Some of this is because financial analysts look at industry predictions as well and these can be wholly misjudged. For instance, LaRusse says in 2015 it was predicted that by now there would be a cure for malaria, organ transplants would be grown from stem cells and self-driving cars would be on the roads in major cities.3
While developed market politics once followed certain conventions, now there is growing complexity resulting from the ‘new world' of politics. These days, she says, it seems holding onto power involves creating a common enemy, and controlling and/or discrediting the press. This in turn creates an ever more uncertain backdrop.
In the world of bonds this adds up to the necessity for greater flexibility and a wider range of tools for investors. The shape of the credit markets is shifting; with the BBB universe once accounting for roughly 20% of the investment grade market and now comprising closer to 50%. This means the risk is higher, and as such the appeal of more flexible fixed income mandates is growing.
As banks' lending criteria tightens and interest rates remain low, many businesses are turning to the capital markets for their borrowing, which LaRusse says "is fine, but then people have to realise they need to run their businesses slightly differently if they have more leverage."
She says this mind set supports an improvement in BBB credit fundamentals, given higher interest coverage that offsets higher leverage and also seeing a tilt towards larger companies, which are likely to demonstrate more resilience in an economic downturn.
LaRusse says there are also opportunities to be found in "rising stars" – that small portion of the market currently set to migrate upwards from high-yield to investment grade. She names Sony, Tesco and Sydney Airports as surprising recent upgrades; in her view, sound business models with transparent cash flows and stable earnings.
Meanwhile, with the high-yield market shrinking in recent years, the investment grade universe has "exploded". LaRusse points out the opportunity in high yield is greater as more companies are turning towards the (more flexible) loan market.
"I find that interesting because the company hasn't changed its creditworthiness when it does that but it is seeking more flexibility," she says. "After six months you can change the coupon, you can change the maturity. In the high-yield world you have a longer period where you can't change the terms, so the investor who buys that has a longer degree of certainty over the coupon they are going to get, which is enticing."
While duration is being pushed out, LaRusse says so too is dispersion by credit rating category, which demands active selection.
Defaults have been lower, but she says levels are expected to rise, as we brace for an economic slowdown, although they are likely to be more prevalent in the high-yield space.
She also warns of the increasing use of "distressed exchange" in the high yield space. "When is a default not a default? When it is a distressed exchange. The issuer might just offer a new bond, probably not giving the full principal back, they might offer a bit of security, or defer the coupon, but it is not defaulting," she says. "The company is basically trying to buy itself some time, and reduce their leverage. It can help give businesses a bit of breathing space."
1 Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.
2 Expert Judgments: Financial analysis and weather forecasting Tyszka and Zielonka 2010. Washington State University Psychology of Investing.
3 Big Think October 2015.
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