High-yield bonds have been under pressure from rising bond yields, and for the year to date the total return of the benchmark Bank of America Merrill Lynch U.S. High Yield Index is flat. Meanwhile spreads between high-yield bonds and comparable U.S. Treasuries, which indicate whether the asset class is attractive or not, have narrowed to about 360 basis points (bps) from 373 bps last December. In contrast, the all-time low was about 250 bps in 2007.
The spread could tighten even further, argues Geof Marshall, senior vice-president at Signature Global Asset Management, a unit of Toronto-based CI Investments. Marshall oversees about $16 billion in assets split roughly equally between high-yield bonds and investment-grade bonds. "It [the spread] is on the expensive side of historical averages. But there is a little room for more compression, maybe 20 or 30 bps in the next 12 months."
A 22-year industry veteran who joined the Signature unit in 2006, Marshall argues that economies are late in the cycle. "Equities need earnings growth to work and credit [high-yield bonds] needs earnings stability and balance-sheet discipline to work. But credit is possibly a little ahead of the business cycle, although it's hard to say how far ahead."
In Marshall's view, the asset class got a huge boost after the 2008-09 financial crisis as bond yields shot through the roof and then tumbled as issuers worked to clean up their balance sheets. There was a market hiccup in 2015 when the crude oil price collapse triggered defaults in energy and commodity players, and they, too, had to clean up their acts. However, the contagion did not spread to other sectors. But now that the market has shifted into an extended cycle, fiscal stimulus in the form of U.S. tax reform raises many questions.
"What's in store for 2019?" asks Marshall. "What's the impact of tax cuts on earnings growth and on the consumer? These tax cuts have to be paid for, largely by government deficits and more bond issuance and could therefore push yields even higher. The question is: At what point do higher borrowing costs begin to bite into the economy?"
It's uncertain when that will occur, as Marshall contends that the oft-quoted "lower for longer" period of low growth and low interest rates may continue for some time. "Credit is competing with higher government bond yields, which are risk-free. But I am seeing a lack of supply in the high-yield bond market," observes Marshall. "With tax reform, and the elimination of interest deductibility, companies will view debt as less efficient in the capital structure. Going forward, they will have less debt -- but that trend will materialize very slowly over the next 10 years."
Still, Marshall has no doubt that a recession will inevitably occur in the U.S. and spreads will widen, perhaps by as much as 400 bps. "What I worry about is that I see more excesses in the investment-grade market, particularly the BBB-rated bonds," he says, adding that some rating agencies are being very liberal with their ratings on mergers and acquisitions.
"I see a lot of M&As with BBB-ratings at four or five times debt-to-cash flow. To me, that's not a BBB metric," adds Marshall. "I worry that the next downturn will see some fallen angels. Large complexes will be downgraded into high yield -- and these are billion-dollar complexes. There will be a lot of bond supply, all at once."
Back in 2015, a number of major Canadian energy and global metal producers were downgraded, Marshall notes. This scenario could well play out again and many bond managers will be forced to sell because they are not allowed, or not able, to hold bonds newly rated as high yield.
"A lot of bonds will come into the market at very low prices," says Marshall. "It's a great opportunity if you are not beholden to the index. And it's a great opportunity if you are underweight and have cash."
That's precisely his strategy. For instance, the 5-star rated CI Signature High Yield Bond Corporate Class F has only 61% in high-yield bonds, along with 19% in floating-rate loans, 8% in investment-grade bonds, 7% in floating-rate bonds, 3% in preferred shares and 2% in cash.
Marshall tends to be highly diversified and owns about 300 high-yield bonds, spread across 120 companies. "The fund has an 88% active share. That means it looks nothing like the benchmark." A year ago, the fund had about 70% in high-yield bonds. In terms of duration, the fund is around 3.3 years, versus 4.4 years for the index.
In a similar vein, the 3-star rated $964.2 million CI Signature Corporate Bond has about 48% in high-yield bonds and 52% investment grade. A year ago, the mix was the other way around.
"Our biggest trade is increasing the quality of the portfolio," says Marshall, emphasizing that the portfolio changes have been gradual. "The other trade, in terms of being defensive, is overweighting energy and metals companies. We also own preferred shares by institutions such as Credit Suisse International."
One representative energy play is NuVista Energy, which produces condensate in the so-called Montney formation that straddles Alberta and British Columbia. "We are believers in the story and know the value of their acreage," says Marshall. The B-plus-rated bond, which matures in 2023, pays a 6.2% yield.
"At some point there will be a fire, and only one door, and everyone will be racing toward that door," says Marshall. "I want to be on the other side of that door, when it happens. That's why I am doing these trades now."
