By Azhar Hussain
Investors remain preoccupied with trying to work out if we are in the middle of another great bubble, again created by easy monetary policy, and identifying what opportunities are available following the strong gains in debt and equity markets following the lows of March 2009.
Despite central banks pumping an almost endless amount of liquidity into the system, we are still mired in a low growth world. While the jury may be out in terms of the full success of quantitative easing, it has nonetheless enabled us to escape a far more serious situation. The outlook remains one of cautious optimism; the monetary transmission mechanism is slowly grinding into gear, but we are some way away from serious inflation and, for the most part, our indebtedness as individuals and sovereigns remains high, limiting the growth capacity of the economy.
In an environment where the opportunity cost of capital is high, returns from cash on deposit are minimal as low single digit inflation slowly erodes any gains – the magic of compounding unfortunately works negatively as well as positively. In contrast, global high yield is an asset class that can deliver a real inflation adjusted return. With $1.5trn in high yielding corporate assets, the market is large, liquid and diversified. High yield is now the bastion of reputable high street names from Burger King to Jaguar Land Rover to Odeon. As the cost of capital – on an absolute basis in the debt markets – is low, companies are being incentivised to raise more debt to invest. In addition, further expansion is anticipated, driven by the growth of emerging market corporates and the continuing disintermediation of the bank lending markets in Europe.
As an asset class, high yield has outperformed both equities and government bonds on an absolute basis for the last decade and importantly too, continues to outpace equities on a volatility-adjusted basis. However, any protracted period of outperformance naturally leads to questions as to how long it can continue. High yield bonds are at their lowest ever yield levels and although some view this as cause for concern, remember that government bonds and investment grade credit are in similar terrain. What counts is that the yield spread between government bonds and high yield bonds continues to be at levels more akin to 2004/05 than 2007. This is important because we can gauge the value in high yield bonds by a simple measure of looking at the forecast default rate and the forecast recovery rate. Subtracting the loss rate from the spread provides an indication of how much excess yield we earn to own the asset class. This measure shows that high yield is currently still returning well in excess of 400bps of losses.
While the asset class remains attractive overall, we believe that the opportunities can be maximised by an event-driven, stock-picking approach. Many high yield corporates are in some form of structural transition and so offer excellent stockpicking opportunities. While the number of issuers intending to remain in the high yield area for the long term is increasing, most companies borrow extra money for specific reasons and with an intention to repay that debt with cash rather than with additional debt. The market is also dominated by mid-size companies that are in a state of strategic flux, meaning that most high yield bonds never mature, as companies are taken over and the debt is redeemed early. In the current market environment corporate activity is increasing, and so are our opportunities to deliver returns in excess of the market.
Azhar Hussain is head of global high yield at Royal London Asset Management
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