Payden & Rygel: A world of opportunity in global high-yield bonds

20 maart 2024

The higher yields on global bonds are attracting increased interest from investors, according to Timothy Crawmer, Director and Global Credit Strategist at Payden & Rygel.

We asked Crawmer and his colleague, London-based Frasat Shah, about the asset class and what opportunities and risks it poses for investors.

We've seen news coverage about 2024 being a very strong year for the bond market, maybe even exceeding the expectations for equities. What are your views?

Tim Crawmer: 'On the bond outlook for 2024, a lot of positive things are going on that are going to support fixed income. The main thing is that higher yields are attracting a lot more demand from investors. Also, given that equities had such a strong year last year, we have seen big funds take some chips off the table in equities and put them into fixed income, especially at these higher yields.

There's a lot of demand that's supporting the market. It's really going to come down to what government bond yields do in 2024 to dictate the total return for fixed income. And, as a result of that, how much duration is in your fixed income product that you are managing? Because, the more duration, the more impacted they're going to be by changing government bond yields. Global high-yield has a lower duration so it's going to be less impacted by what happens with government bond yields and more impacted by what happens with credit quality, how strong the economy is, how much interest there is for global high-yield. And we think all of those things are really positive for the market.'

What about the global economy? It exceeded the expectations in 2023. Do you see it exceeding expectations in terms of its growth in 2024?

Tim Crawmer: 'We expect there to be strong growth in 2024, especially in the US. The US is setting up  positively from a macroeconomic point of view because the labor market is strong, business activity is picking up and being supported by the strong labor market. The expectation is that central banks, especially the Fed, will start to ease monetary conditions, which will be another tailwind for the economy in 2024. We think that gross domestic product (GDP) is going to be pretty strong and will at least meet expectations and could continue on the path of exceeding expectations similar to what happened in 2023.

Outside of the U.S., it's a little bit more of a murky situation, but it still should be positive, just not as robust as the US.  A lot of that is because there are areas globally like China that are slowing down and China activity has ripple effects through other parts of the global economy, especially Europe. Europe is such a heavy exporter to Asia and China, and that's going to weigh a little bit on the European market and Asian markets. But we still expect there to be positive growth. It's not a negative story, just not as positive as the U.S.' 

What do you hear from clients in London?

Frasat Shah: 'There's been a long-held expectation that Europe is going to underperform the U.S. and it has been true to an extent. There's definitely been a divergence in growth. There was pessimism that was priced into European markets in 2022. It didn't turn out to be as bad as expected. Everyone was worried about substandard growth due to the impact of higher energy prices.

Going forward I think it's fair to say that European growth will be more weighed upon by external factors like China, given the export economy that it is and the reliance of Europe on China. With that being said, and with expectations low in Europe, in our eyes there’s no obvious catalyst for a break in market confidence or a significant downturn in global GDP. We think it could very well be possible that Europe, perhaps not catches up to the U.S., but could outperform expectations.'

In the U.S., we went into the year expecting that the Federal Reserve was going to lower rates. Now it seems the dialogue is changing. Some people are even saying that they're going to raise rates again. What are your expectations? 

Tim Crawmer: 'Our view is that we're going to see the Fed cut rates at some point in 2024. The question is when that happens or if it gets pushed into 2025? We did have some hotter-than-expected inflation data early this year that has pushed people into that camp of the Fed holding out and doing it later than what was originally expected.

We think that those numbers were somewhat seasonally-adjusted and they showed higher readings just because of seasonal factors more than showing a change in the trend. Once that trend resumes and shows a downward trajectory for inflation, the Fed will move into the camp of cutting rates because rates right now are restrictive and they know it. They don't want to keep it at these levels longer than they need to because that would weigh heavily on the economy.'

What about  central banks in Europe? Is the view that they’re not going to be moving downward too soon?

Frasat Shah: 'I think it's a bit more nuanced. At the moment with what's priced in you'll see that the European Central Bank (ECB) and the Bank of England have a similar number of cuts priced in for this year to the U.S. We would say that if we were to bet on a market that's more likely to cut, we would say it's over here in Europe. I think that's for a few reasons. Growth, as you've noted earlier, is more lackluster here. But also, especially in the UK, we have higher interest rates feed in quicker to our economy because mortgage terms mostly shorter than five years.

I think the Bank of England is quite wary of that, and we think it's a matter of time before the force of all the rate hikes that we've experienced over the last few years start to weigh more heavily on the consumer and you start to see a divergence in consumer appetite, especially over here in the UK relative to the U.S. All of that to say if we were to bet on a market cutting first, it would probably be the UK, perhaps then followed by the ECB, and then the U.S., just from how the data falls currently.'

Tim, you agree with that? It's an interesting point. Who's going to make a move first here?

Tim Crawmer 'I think it is accurate in our view. There just isn't a mechanism in the U.S. for the federal funds rate to impact the economy as quickly as central bank rates do, especially in the UK and then also Europe. So, I think that makes the ECB and BOE quicker to pull the trigger than the US.'

Let's talk about the high-yield market. It had a great year in 2023.  In an environment where we don't know what's happening with interest rates, is this still a good environment for high-yield bonds?

Tim Crawmer: 'I think it's going to be hard to repeat what we saw in 2023. For global high yield, we saw close to 13% return for 2024. 2024 is going to be a harder year to repeat what we saw in 2023 because spreads rallied in to the low 300s on the global high-yield index.

Historically, it's been pretty tough for them to rally in a lot further than that level so capital appreciation is going to be limited. That leaves the carry component and the coupon as the main driver of returns. We think it's going to be a really supportive environment for investors to capture that carry.  We expect that to result in a 7% to 8% type of return for global high-yield, which is very good but it's not as good as last year when you got 13%.' 

Frasat Shah: 'Yes, it was extraordinary. The only thing I would add is default expectations remain low. So, I don't think you've got a significant headwind to returns from defaults. Expectations are about 2% in Europe. I think they're closer to 3% in the U.S., but also recovery rates have been robust. So, it seems there's a good case to be made for a high single digit return here but not quite 13%. We're not at the same starting point.'

Why do high yield issues have shorter duration that investment grade bonds?

Tim Crawmer: 'It's really driven by investors who are wary to give high yield issuers borrowing terms that are significantly longer than five years because they want to be able to readdress the credit quality of the issuer on a regular basis before they underwrite it again.'

I read that your portfolios are driven by three pillars, duration, currency, and sector.  Is one of these factors over-weighted or are they all given equal weight?

Tim Crawmer: 'On the global high-yield front returns are really going to be driven more from credit quality and picking the right securities in the portfolio than duration and currency decisions. Most investors in high yield really are not investing in the asset class with expectations that a manager is going to deliver alpha from making interest rate and currency calls in the portfolio.

So, we try to keep that exposure pretty minimal in the portfolio and close to the benchmark because we really want credit to drive the out-performance. In global high-yield it's all about working with the analyst team, digging through our credits, and picking the best issuers out there that have the best potential to outperform the benchmark.' 

In the high-yield global sphere, are there sectors or countries that you favor? Or you are always looking bottom-up at all of this? 

Frasat Shah: 'When it comes to sectors, it's worth noting that the higher rated portion of the high-yield index on a spread basis is near historical tights, and that tends to be true somewhat across sectors. That being said, I would say that we are finding incremental value in communications, the right energy names, and the healthcare sector, but really at this point in the valuation cycle it's much more for us being issuer-specific than being a sector-specific strategy.

I would say we've also been finding value by looking to other high-yielding markets. So, some high yield emerging market sovereign debt exposure and some BBB CLO exposure, while not overriding the main thesis of the strategy which is high yield corporates. It hasn't so much been a broad sectoral tilt, more of an issuer-by-issuer story as well as some higher beta asset classes added into the portfolio as they’ve offered some value as well.'

What about new issuance? How does that fit into all of your thinking?

Frasat Shah: 'It should be higher this year. 2022 was a very quiet year. 2023 picked up a bit off of 2022. Last year in the European market, we had just under $50 billion. The U.S. market was just under $200 billion. We think that number has upside potential given the refi needs, due to the maturity walls that we have in 2025. The high-yield market likes to refinance at least a year in advance.  Investors like to see that issuers can term out their upcoming maturities a bit earlier than in other markets. From an investor perspective, that gives us more investment opportunities to choose from.'

There anything that keeps you up at night that you think could derail this whole story for high yield?

Tim Crawmer: 'I think it's going to be driven by idiosyncratic stories. What will keep us up at night is just making sure that we do our fundamental work on every single issuer, because given that spreads are at historical tights, if you get something wrong and something goes bankrupt, there's a lot of downside room on that position. So that's what we're trying to protect against, and if you can minimize that idiosyncratic downside this year, I think you will set yourself up to perform pretty well.'

Frasat Shah: 'There's always things that keep you up. To the extent that interest rate cuts aren't delivered as expected and the fight on inflation is deemed by the market to have not been won, the reassessment of where we are in the cycle could cause significant interest rate volatility that would weigh on markets like high-yield corporates. You've got a lot of elections this year, the U.S. election particularly. The market will be paying close attention to fiscal rhetoric which could cause the treasury market or gilt market to be volatile.  If there was a violent move in underlying Treasury curves, then I think that's something that would be negative for the market.'

What about the elections? There are a lot of countries having elections. You see the U.S. is the really seminal one here but what about other countries?

Frasat Shah: 'The US is definitely center stage. I think it's undoubtedly the one that matters the most, especially from the U.S. budget perspective.'

Anything that you see in the market that's important for investors to know about or you hear from your clients that they're concerned about?

Tim Crawmer: 'Everybody is talking about spreads and do spreads compensate you for risk at these levels, because we have tightened a lot. Everybody is focused on that and everybody recognizes that the economy is in a good place. The technicals are really good with a positive supply-demand picture given all of the interest for fixed income. It's really just that unknown, what could cause a selloff in risk assets, whether it's geopolitical, elections, a rise in inflation, something that people aren't expecting, is what investors want to talk to us about on calls.'

If we're getting similar yields from high-yield and investment grade, is it still worth the risk to go into high-yield? 

Frasat Shah: 'I think one of the things that high-yield has over investment grade is it's not as sensitive to interest rates. Interest rates are such a big driver of volatility in the fixed income market currently that, to the extent we see a resurfacing of inflation, rates volatility in the treasury market, that's something that tends to weigh more on investment grade returns than it does high yield.'

Tim Crawmer: 'Just to put that in a framework, if your biggest fear this year is that inflation could pick up and weigh heavily on fixed income markets, that's really going to be a government yield issue. And given the fact that high-yield is a three-year duration versus investment grade at an eight-year duration, a 100-basis point increase in rates is only going to cause the high-yield market to sell off 3% and the coupon of seven-and-a-half will more than make up for that. Whereas investment grade will cause it to sell off 8% and their coupon is 4% or 5%, let's call it. That's not going to make up for that move, so there's a better buffer with high yield.'