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As an active high-yield investor, I am excited about the opportunities offered by the new macro regime with its higher levels of cyclicality and dispersion between regions, sectors and assets. At the same time, I think caution is warranted as the environment remains uncertain and volatility is likely to persist. However, I believe current all-in yields provide a meaningful cushion to investors. Further, the growing differentiation among sectors and regions in the high-yield market is, in my view, starting to create attractive opportunities for bottom-up focused investors, with Europe currently the standout region.
Central banks seem to be winning the fight against inflation, although at this stage it remains unclear whether that is attributable to tight monetary policy or easing supply shocks and depleted consumer savings. Markets have responded with significant spread tightening, but this may be somewhat premature. Normally at this point in the economic cycle, relatively weaker consumer strength should translate into slowing investment spending, but fiscal spending programmes may distort the true picture. Looking at the largest high-yield markets in aggregate, I see Europe currently better positioned than the US as its consumers have stronger balance sheets and the region has yet to enjoy the benefits of more accommodative fiscal policies. While I still think there is a reasonable likelihood of a mild global recession, the balance appears to be increasingly tipping on the side of a soft-landing scenario, even if a number of European economies, most notably Germany, currently remain vulnerable to slowing growth.
Higher rates have had a limited impact on corporate earnings thus far, but I expect further deterioration in the coming quarters as the economy slows. I don’t think higher interest expense alone will trigger a wave of defaults, despite an upcoming wave of expiring maturities. Instead, I anticipate that a decline in earnings will likely be the primary driver of weaker corporate fundamentals, suggesting that fundamental research and security selection will be even more important to identify companies with stable-to-improving credit profiles.
While default rates have increased, I do not see a full default cycle on the horizon. Instead, my forecast is for defaults to remain in line with historical averages — which we calculate to be 4% – 5% — given the higher-quality composition of the high-yield market relative to past cycles. Controlling for compositional differences between the US and European markets in terms of, for instance, ratings and sectors, this translates into a distinct relative advantage for Europe, especially when combined with the supportive macro factors mentioned earlier. As a result, I see several attractive opportunities to incrementally add risk in Europe over the near term.
From a sector perspective, I am not observing the same leverage buildup as occurred during previous late-cycle environments. I believe this is, in part, due to the strong starting point of corporate balance sheets, but also because many of the riskier deals have taken place outside the high-yield market and in the private credit market. This trend of highly levered companies being denied access to the high-yield market and needing to then source their financing elsewhere, constitutes, in my opinion, a crucial factor in why private credit markets have grown so much faster than their public equivalents, as Figure 1 illustrates. Based on data from Bloomberg/ICE and Bank of America, our research shows that the seven-year growth rate of the private credit market has been approximately 99%, compared to only 13% for the high-yield market. While this higher growth pattern also reflects a broader coming of age of private credit, it also implies that the high-yield market may be somewhat insulated in the event of a prolonged recession.
In this type of uncertain environment, I think it’s even more vital to prioritise companies with sustainable competitive advantages and avoid sectors experiencing increased capacity. These durable competitive benefits can be, for instance, having a cost advantage that is hard to replicate or possessing high-quality intangible assets such as a brand or patent. I tend to avoid companies that do not have any of these lasting competitive advantages as, in my opinion, they are unlikely to outperform over the long term. For example, I have a negative view of a leading US streaming service provider primarily because its competitive advantage cannot easily be defended. Subscribers can switch without major costs to one of the many competing multiple streaming services for a similar level of service and cost. Despite very low leverage levels, the company has consequently not been able to generate free cash flows consistently and our analysis suggests that capital expenditure on content will have to remain high to stop subscribers from leaving. Conversely, I like a European telecommunications provider because of its “efficient scale” and ability to consistently generate free cash flow. The company faces very little competition and customers have limited scope to switch to another provider while potential new entrants to the market face high barriers.
I complement this framework with a wide range of other perspectives — with a particular focus on capital cycles. Specifically, I seek to avoid sectors or geographies that are increasing in capacity as I believe these areas will experience higher default rates if the cycle turns. For instance, our team is cautious on the automotive and utilities sectors as we are seeing increased supply of electric vehicles and renewable energy. The European real estate sector, on the other hand, may offer interesting opportunities as we witness a growing dispersion in access to refinancing between the “have” and “have not” companies.
I recognise that there are many risks to the economic outlook and further volatility is likely in the near term. At the same time, I see opportunities emerging — particularly in Europe — for investors willing to do the research and venture into “out-of-favour” areas of the market when the time is right.
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