BALANCING YIELD AND RISK

Opportunities in High Yield

BALANCING YIELD AND RISK

Low rates have pushed yield-starved investors further down the quality spectrum - and they could end up reaching for too much default risk or further down the liquidity rabbit hole. Which areas remain attractive in the High Yield space?

ALLOCATION TO HIGHER-QUALITY HIGH YIELD PROVIDES SEVERAL BENEFITS

As the global high yield market expands, providing increased opportunities and improved characteristics to investors, we believe a permanent allocation to higher-quality high yield is warranted as either a complement to core allocations or as a replacement for illiquid or high-risk high yield alternatives, such as private credit. Considering the alternatives given the current environment, an allocation to investment grade credit may be enhanced by adding exposure to higher-quality high yield, moderating interest rate risk while avoiding excessive default risk.

In comparison, a complement of traditional high yield does not necessarily isolate the same benefits and may expose investors to other risks. Amid the low yield environment, many traditional high yield managers have gone down in quality, leaving investors potentially overexposed to CCC. When these allocations are further paired with long/short strategies, direct or distressed lending, or other illiquid strategies, investors bear potentially excessive and unintended default and liquidity risks. We believe an allocation to BB/B-rated credit provides several advantages over traditional high yield mandates and non-traditional high yield alternatives.

 

1. Global BB/B can enhance investment grade credit exposure, creating a multi-purpose, defensive high yield strategy that seeks to avoid default risks of lower-rated high yield. Normally, in a standard barbell approach, the duration from investment grade credit seeks to protect portfolios that have moved into lower-quality, lower liquidity segments. However, given the risks associated with reaching down the spectrum of quality and liquidity, we advocate a defensive approach, which tilts toward higher quality. When duration warrants, investment grade credit is utilized for deflationary protection. Conversely, our approach will go down in quality when needed by focusing on select BB/B rated credit to generate returns comparable to traditional high yield while avoiding CCCs and alternative credit, as well as their characteristic default and liquidity risks.

Global BB/B high yield can enhance investment grade credit in several environments, creating a defensive, multi-purpose high yield strategy. Higher-quality high yield typically has less duration sensitivity than BBB or investment grade credit, which means that in an environment of increasing rate volatility, the incremental spread/yield offered by these higher-quality high yield issues may provide some cushion to investors.

In rising rate environments, higher-quality high yield offers strong outperformance potential relative to investment grade credit while still providing minimal default risk over lower-rated credit. These characteristics of higher-quality high yield become particularly relevant and attractive as investors face a period of rising interest rates, including the potential for the U.S. Federal Reserve to accelerate the pace of its rate hikes. For example, when 10-year U.S. Treasury yields rose more than 100 basis points (bps) over 3-month, 6-month, 9-month, and 12-month time periods, global BB/B high yield showed consistently strong outperformance over investment grade credit.

 

2. Attractive total return with lower volatility. Selective investing in global BB/B-rated bonds is an attractive way to earn income and total return with lower volatility relative to lower-rated credit. Investors can participate in the upside potential without incurring significant default risk.

 

3. Lack of structural constraints and illiquidity premia. While the changing regulatory environment following the Global Financial Crisis has led to bank deleveraging and constricted access to capital, it also has created new opportunities for investors, including direct lending. These new products have helped to fill a gap created by the stringent postcrisis regulations, with private lenders affording middle-market enterprises access to capital no longer available through traditional loans. However, while these unconventional products may lure yield-seeking investors with the potential for sizable returns and low correlations to other asset classes, they also come with significant structural constraints, such as lock-up periods, price volatility, lack of availability or restricted access, and the potential need for investment specialists—all necessitating sizable illiquidity premiums. Certain qualified investors may benefit from these illiquidity premiums, but they typically must also be able to comply with regular lock-up periods and other constraints that considerably restrict access to principal. And as with any investment, loss of principal is possible.

 

4. Price transparency and historical performance.  Furthermore, alternative investments such as direct lending mandates are characterized by limited price transparency. These illiquid assets are not marked to market nor are they actively traded. These products are relatively untested, with no track record through various rate environments or economic climates, including recessionary conditions. Conversely, high yield, particularly higher-quality high yield, offers investors relative safety in the form of robust liquidity, transparency, and a time-tested understanding of historical performance, while still providing attractive risk-adjusted return potential.

 

CONCLUSION

The actions of central banks since the Global Financial Crisis have pushed yield-starved investors further down the quality spectrum into distressed investments, long/short strategies, and direct-lending mandates. As a result, the traditional investment grade/high yield barbell, where the relative safety of investment grade credit is offset by the increased risk and yield potential offered by a corresponding weight in high yield, may need to be revisited.

With traditional high yield managers increasingly venturing into CCC and lower, investors may end up reaching for too much default risk or further down the liquidity rabbit hole. And, as some investors add private credit to their investment mixes, there is a potential for significant overlap in default and liquidity risks. For investors seeking incremental yield in the current low rate environment, but with less price volatility than associated with either the equity market or the lowest-quality segments of the high yield market, or with better transparency and liquidity risk than private credit, BB/B-rated global high yield bonds may offer an attractive risk-adjusted return opportunity. Furthermore, given the expectations for ongoing volatility and uncertainty in global credit markets, a flexible investment strategy and an experienced global manager may offer opportunistic exposure and the ability to successfully navigate different economic and credit cycles, providing the potential for superior risk-adjusted returns in higher-quality global high yield.

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The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.