Rising yields and modest default rates among corporate bond issuers look set to attract new investor interest to opportunities in the short-dated high yield debt market, says Insight Investment¹ senior portfolio manager Uli Gerhard.

As global markets rebalance following a long period of low inflation and interest rates, fixed income markets are showing signs of marked recovery as investors target rising yields and seek to diversify their portfolios.

Insight’s Uli Gerhard compares the current global credit marketplace with a fertile forest, which can offer foragers for food a wide range of mushrooms to harvest.

“Just as a forager for mushrooms in a forest is faced with a range of options, from highly edible fungi to more poisonous species, investors are faced with both good and bad choices. The skill of both forager and investor is to make good selections and avoid the bad choices,” he says.

Among the more appetising market prospects within fixed income, Gerhard believes the high yield debt market can provide some attractive choices for investors, particularly those who invest at the short end where short investment time frames, he believes, can offer more predictable outcomes.

Risk v return

Describing the appeal of high yield credit investment, Gerhard says: “Investors are quite rightly concerned about risk. But if you look at the so-called safe fixed income asset class of investment grade, it hasn’t made a lot of money in recent years. In contrast, we believe high yield bond yields remain at attractive levels and their spread to government bonds represents fair value. We would say to investors that high yield is not that scary!”

“There are several reasons we believe high yield is safer than some investors think. Firstly, global corporate profit margins remain relatively high, and leverage also appears to have fallen significantly in the European high yield space, while investment grade leverage has actually increased over the same period. High yield default rates remain very low by historic standards, and we believe they will continue to remain lower than many analysts think.”

Commenting on the historic default outlook for high yield assets, Gerhard points to a broadly benign picture. He adds that defaults within the asset class only tend to spike when markets are confronted by major shocks or dislocations.

“In fact, the high yield sector has seen very few recent defaults. We only tend to see rising default levels when something extraordinary happens in the market. In 2020 we had the Covid 19 pandemic which presented a major challenge and triggered a sharp sell-off in high yield assets. Most of the time, if investors pick the right companies, they should be OK.

“The most important thing for high yield to work is to have good analysts underpinning investment research. Investors need smart people who understand cashflow to help them pick the right investments as the differentiation between good and bad companies has massively widened in recent years. Stronger companies tend to be those that have longevity, that can pay their interest rate bill and have a clear and credible business plan.”

Gerhard also believes that by taking a truly global approach to high yield, investors can pinpoint opportunities while avoiding riskier assets in specific markets, thereby diluting overall risk levels in their portfolios.  
 

A short-dated approach

According to Gerhard, short-dated high yield investment has “started to shine” over the past three years. He believes a short-dated approach brings specific discipline and advantages, reducing duration and giving investors a better chance of predicting investment outcomes over shorter time frames.

“When we look at credit, it is much easier to look two years in the future than five years. Investment analysts can predict the numbers quite accurately over the next two to three years, and if you run short-dated high yield your duration is much shorter. If you can see cashflow coming in and want to be paid over a two-year time frame, the probability of default is also low,” he adds.

Commenting on the wider outlook for the high yield market, Gerhard says many high yield companies which were historically small are, in many cases, now much bigger. Often, he adds, their leverage has declined, and these companies have been making concerted efforts to pay down their debt.

“While spreads are somewhat tight versus history in the high yield market, we believe fundamentals are strong and defaults are being contained. In our view there is an opportunity to lock into some attractive rates and we believe the high yield bond sector will continue to offer scope for some positive returns in the year ahead,” he concludes.

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