At a glance
- The extended period of low and near-zero interest rates from 2009 onwards saw European High Yield bond yields follow suit, reaching sub 3%
- But the subsequent move higher caught many investors unawares/off-guard, re-emphasising that volatility is often relatively short lived and the importance of watching longer-term trends
- With yields having become more attractive and volatility creating opportunities for active management, we believe current market conditions are a compelling opportunity for investors to reconsider their fixed income allocations
Introduction
In investing, where trends can shift rapidly and market conditions are ever-changing, the allure of fixed income was that it did what it said on the tin: stable and reliable returns. The global financial crisis (GFC), however, saw a transformation of the landscape marked by falling and persistently low interest rates and, subsequently, yields. Suddenly fixed income wasn’t so reliable. But with that movement in reverse, we believe bonds could be
a safer bet than equities over the next few years.
The high yield universe
High yield as an asset class in European capital markets is around 25 years old. In some circles it might still be considered a bit of a marginal asset class – despite seeing more than two decades of sustained growth (Figure 1). Today in high yield, many of the companies generate at least €100 million in earnings and bring tranche sizes to the market of at least €500 million per bond (€250 million is the minimum size to qualify for the market). They include household names such as M&S, Avis, Land Rover, Asda and Virgin Media1.
Figure 1: The European high yield universe
Source: ICE BoAML index HP00 European currency High Yield Index, as of 30 April 2024
Understanding market shifts: past to present
Quantitative easing policies introduced in the wake of the GFC sought to reduce volatility. Low and near-zero interest rates became the norm for more than a decade, with bond yields following suit. When interest rates once again started to rise it was a surprise to investors who had experienced nothing other than low rates and low yields. This meant that those who were long duration were not positioned for the move higher. In 2022/23 as yields went up quite dramatically – and the high yield universe is currently true to its name with yields of around 7%2 – this hurt a lot.
The attraction of duration is that it gives you returns over several years: with a five-year 7% bond, for example, that yield is locked in over five years. If inflation continues to come off as expected, interest rates should also reduce. But duration means you have the opportunity to earn that higher yield for longer – all as yields elsewhere start to decline.
Credit spreads are less exciting, currently inside their long-term
average. However, a compelling part of high yield is the breakeven
return. This is effectively the cushion you get from a high yield
product in a period of spread widening. Given where yields are,
spreads are currently able to widen several hundred basis points
before you start to lose money on a particular trade (Figure 2).
Figure 2: European High Yield valuations (LHS) and breakeven rates (RHS)
Source: Bloomberg and Columbia Threadneedle Investments as at 31 March 2024. Breakeven rates are calculated by dividing the index yield to worst by index adjusted duration. Index adjusted duration is calculated by taking away 1 to account for rolldown. This breakeven shown gives an indication of how much yields can rise before the initial yield of the market is wiped out.
This is why fixed income investment is so interesting, and also why during that long, low period of volatility there wasn’t much income left in many parts of the market. That has changed.
As we go through 2024 the economy is quite resilient. Data from the US is surprisingly robust and financial conditions are not particularly tight, which is supportive. Labour costs remain quite firm, with only regional signs of weakness. Inflation will, we think, remain higher than central bank targets. There are geopolitical concerns, which are a big driver of how we think about risk. Overall, however, we believe this environment, taken with improving yields, is a good entry point relative to recent history.
The longer-term is also promising, emphasising the importance of maintaining a balanced perspective and focusing on fundamentals. Indeed, with decades-long experience within high yield it can be seen that volatility is often relatively short lived, and what is really important are longer-term trends.
Active approach
At Columbia Threadneedle Investments, we believe volatility provides opportunities when markets are temporarily weak. But the key to this is active management. The composition of bond indices is based on amounts of debt. If a company decides to increase its leverage, a passive investor effectively agrees to lend them as much money as the company wants – with the implied outcomes that brings. This isn’t the case with active management, which allows us to pick and choose, to take advantage of market inefficiencies and really understand individual credits.
We aim to achieve this through thorough credit research and risk management. Our portfolio management approach – with collaboration between portfolio managers, dedicated high yield analysts and broader investment analysts – combines investment research, responsible investment criteria and risk analysis to identify low-risk names with strong performance potential. We are looking for the inconsistencies in ratings that could allow us to buy a single B-rated company and see that upgraded to double B, and this meticulous process has enabled us to consistently deliver over the long term while maintaining lower volatility.
Conclusion
Current market conditions present a compelling opportunity for investors to reconsider their fixed income allocations. With yields becoming more attractive and volatility creating opportunities for active management, now is an opportune time to explore high yield investments. At Columbia Threadneedle Investments, our global reach, research intensity and commitment to responsible investing mean we are well placed to navigate the complexities of the fixed income landscape, helping investors position themselves for long-term success amid a changing investment landscape.
