Why High Yield Bonds Will Get Better

“It’s been a tough year for bonds in general,” says Gambino, vice-president and senior portfolio manager, global fixed income and currencies at Toronto-based RBC Global Asset Management Inc. (RBC GAM). “If you look at the high-yield market, it’s down 11% as of Sept. 15. Emerging markets bonds are down about 19%. It’s really a story of rising rates early in the year. There were fears of elevated inflation. The U.S. Federal Reserve is determined to tighten financial conditions, so that has created quite a bit of interest rate volatility in the markets.”

Default Fears and Inflation Expectations
As conditions began to tighten in the second quarter, there were fears of an economic slowdown, adds Gambino, a 32-year industry veteran who joined RBC in 1996 (and RBC GAM in 2001). “Basically, we had rising rates and widening spreads [between high yield bonds and U.S. treasury bonds]. The fear was mostly around inflation and the Fed containing inflation. As a result, there were concerns about a slowing economy, pressure on earnings, and concerns about so-called peak credit quality. That has increased expectations of defaults, at least in the high yield bond market. But the story of rising rates is affecting all fixed income categories.”

On the high yield side, the year began with the spread, or differential, of 300 basis points between (bps) yield bonds and the interest rate curve. Although the spread got as wide as 600 bps, today it is 477 bps. Currently, the yield on the benchmark Bank of America Merrill Lynch High Yield Master Index is 8.57%. In contrast, U.S. five-year treasury bonds are yielding 3.62%.

This upward move has adversely affected fund performance (rising rates and performance move in the opposite direction). Year-to-date (Sept. 19) the High Yield Fixed Income category has returned -9.70%, while the RBC Global High Yield Bond Fund F has returned -16.14%. Meanwhile, the fund has a so-called yield-to-worst yield of 7.78%.

On a longer-term basis, the fund has fared better. Over 10- and 15 years, the fund returned an annualized 2.25% and 4.83%, respectively. By comparison, the category returned an annualized 2.75% and 3.64% for the corresponding periods.

The comparison to the category is partly unfair because the fund is lumped in with other funds that do not invest in emerging markets, an asset class that has performed poorly of late says Nava, senior portfolio manager, global fixed income and currencies at RBC GAM, and a 25-year industry veteran who joined the firm in 2004, after earning an MBA at the Rotman School of Management.

Perfect Storm of Trade Trouble, Covid and Inflation
Rising rates are only one component of the downward pressure on emerging markets bonds, says Nava. “In February, Russia invaded Ukraine and it added to the problems [by causing disruptions in global trade]. From there we had a perfect storm, with the Fed becoming more aggressive than expected and China is the other negative ingredient as it slowed down more than we expected. Typically emerging countries get some help from a growing and stable China. This year has not been the case because COVID, while not a big problem in China, has kept them on the defensive and China has not been able to stimulate their economy.”

It’s very difficult to know if the market has priced in all the bad news, says Gambino. “The Fed is determined to meet its inflation target of 2%. And obviously, policy rates look as if they will continue to rise and the market is expecting a 75-100 bps rise in the next meeting,” says Gambino, noting that rates could rise to as high as 4.25%. “We could be in an environment where the bias is still to higher rates and potentially tighter financial conditions. That should lead to a slowing economy and wider spreads. I don’t believe we have completely priced in [all the rate hikes].”

Surprise Hikes Possible
The worst-case scenario, Gambino argues, could be even higher-than-expected rate hikes that lead to tighter conditions and a recession. “In the past, spreads have been even wider and on the high yield side, they have been 900 bps or more over treasuries. But that’s not our base case.” The more likely outcome, he argues, is that spreads move a little wider and yields move slightly higher. “Spreads could widen to 600 bps and yields could go to 9%. This could create some pressure in the short-term, but it should be positive for the long-term performance of the fund. That’s how we view things: we think in terms of one, three and five-year periods, and manage the portfolio accordingly.”

Negative Years Are Rare
Gambino argues that things may start to improve in the next few months, given that a lot of damage has already occurred in the high-yield bond market. “Valuations are becoming much more attractive. We are talking about a high-yield bond market that is pretty high quality and the ‘technicals’ are very supportive in terms of limited supply. But it’s important to remember that if you look at the high yield bond market over the last 30-plus years we only had seven negative years. So it’s very rare to have a negative return in the high yield market. And usually, a negative year is followed by a positive one. I am cautiously optimistic that at some point we shall see much better returns. Most likely it will be 2023.”

For his part, Nava maintains that much of the bad news had been priced into the market. “EM [emerging markets] spreads are at 494 bps and the benchmark [JPMorgan Emerging Market Global Bond Index Diversified] yield is 8.55%. Compared to the past 15 to 20 years, these are levels that are close to the highs [achieved in the past]. I would expect that yields and spreads will stabilize at these levels and come down gradually, maybe in the first half of 2023.”

Buying More Emerging Markets
From a strategic viewpoint, the managers are tilting the portfolio towards EM bonds, since they account for almost 58% of the fund, while high yield bonds represent 40% (the fund’s starting point is a 50/50 mix of both asset classes). “The valuations are more attractive, compared to high yield,” says Nava. “We have been focusing on countries that have more attractive valuations. In the EM universe, I have the full spectrum of quality, from very high to very low. In general, all of them, when combined, are more attractive than high-yield bonds.” Nava adds that since EM has underperformed in the past year he has taken advantage of price weakness relative to high yield bonds. “We look at things with a one, three and five-year outlook so we expect to make gains in these positions.”

The average credit quality for the portfolio, which is comprised of over 450 bonds, is BB or below-investment-grade (BBB and higher are classified as investment-grade). Among the top five countries on the EM side is Mexico, at 3% of the portfolio, as of June 30, Indonesia at 2.2%, Colombia at 2%, the Dominican Republic at 2%, and Saudi Arabia at 2%.

High Rating and Return with LRCNs
On the high-yield side, one representative example is a so-called limited recourse capital note (LRCN), issued by Canadian banks. They are rated investment-grade in almost all cases and their default risk is quite low. But they trade at high-yields. On average, they pay 6.75% to 7.25%,” says Gambino, noting that most of the LRCNs have a BBB rating, have a 60-year maturity date and are reset every five years.

Top High Yield Bond Picks
Other holdings are bonds issued by Medical Properties Trust (MPW), a healthcare real estate investment trust which owns and leases hospitals around the world. “It’s highly rated, Ba1 to BBB, and is known as a crossover-credit that has the potential to cross over from high-yield to investment grade.” The bonds yield between 7.25% and 7.5%.

On the EM side, Nava cites a 2044-dated bond issued by the Dominican Republic, which is rated BB- and is yielding 8.59%. “It has a strong growth profile and is recovering nicely from COVID and tourism is coming back. Debt levels are coming down and they have a 51% debt-to-GDP ratio, with an improving trend.”

Another EM bond is a 2047-dated issue from Oman, which is rated BB- and is yielding 7.91%. “Oil is a big part of what they produce, but they have been diversifying away from oil,” says Nava. “Ten years ago, oil accounted for 50% of its economy and now it’s 30%. What is attractive, for me, is that they have used the proceeds from oil production to pay down debt. We are being compensated with a 7.91% yield.”

Looking ahead, the managers counsel patience. “There are periods of under-performance and out-performance, but over time they will equal out,” says Gambino. “When the high yield bond market is down 11% and yields have gone up as much as they have, and spreads may continue to widen, I am much more optimistic.” Moreover, the quality of the market is the best he has ever seen. “The quality of the index is high and there is quite a shortage of bonds. Globally, the market is shrinking. So, with better valuations, and given such a bad year so far, I am optimistic about 2023.”