Why high yield is like mushrooms

With an economic slowdown likely, Insight Investment's1 Uli Gerhard explains why he thinks this is a good thing for short-dated high yield assets – so long as you pick carefully.

Defaults are likely to rise as global economic growth slows but this isn't necessarily a bad thing for high yield investors, says Uli Gerhard, manager of BNY Mellon's global short dated high yield strategy.

Gerhard says economic growth is slowing but he stops short of forecasting a gloomy scenario, believing we are not likely headed over the cliff edge in a manner similar to 2008. While markets sold off aggressively in the fourth quarter, Gerhard notes they have since stabilised and he thinks it is unlikely the US will fall into recession this year. Instead he believes rates will increase and consequently, defaults may rise.

"We like it when growth is slowing as it stops management from doing stupid things; they become more cautious, careful in their borrowing and spending. By the same token though there are companies that need growth. It is probably best to avoid those."

This is why he compares the current high yield market to mushrooms – some might be toxic, some harmless – it's about picking the right ones. Maturity is another element in this selection. Gerhard points out that during the difficult December period, investors would have made more money in short-dated high yield than the long-dated form of the asset class.

"Over the past two years you could have picked any mushroom. There were so many buyers in high yield it was easy for companies to flog the toxic ones. Today, if you pick the wrong one it could be disastrous."

In managing his short-dated strategy Gerhard says it pays to be brave and not be too benchmark constrained. If he doesn't like a sector, he avoids it altogether. "If they're rubbish, why invest there?" Right now he favours telecoms and selective names in energy but due to his emphasis on free cash flow rates, he notes investors will not see popular names like Tesla or Netflix in his portfolio.

Investing in high yield that typically has a maturity of less than two years and holding to redemption, Gerhard also favours callable bonds and strives for a volatility of almost half that of his comparable index. Gerhard's global short-dated high yield strategy has a current allocation breakdown of c95% in high yield and around 4% in loans while it maintains a zero weighting in credit default swaps. With respect to US high yield versus Europe, Gerhard retains a strong US focus, with some 70% exposure, as, in his view it is a larger, more mature market with better companies and greater secondary market liquidity.

Across the spectrum in sub-investment grade Gerhard favours single B issues to what he terms "over levered" BBBs.

Global default rates: historic and expected
Source: Moody's and Insight as at December 2018.
Source: Moody's and Insight as at December 2018

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.

The value of investments can fall. Investors may not get back the amount invested.

INV01617 Exp 1 July 2019. Published as at 1 April 2019

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Mellon was formed on 31 January 2018, through the merger of The Boston Company and Standish into Mellon Capital. Effective 2 January 2019, the combined firm was renamed Mellon Investments Corporation.