Is the party finally over for high-yield bonds?

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If so, what else is there that can take its place in investors’ portfolios? Our modest proposal is that investors consider global convertible bonds. We feel we are at a turning point for bond markets, where taking credit and duration risk will not be rewarded as it was in the past, but where embedded optionality can drive returns while a stronger, more diverse set of issuers can better preserve capital.

To make our case for the future, we need to take a few steps back into history. That’s because high yield has occupied a useful place for asset allocation in the recent past. In fact, starting from the depths of the Global Financial Crisis and moving into the Great Moderation of the 2010s, economic and monetary conditions could not have been more favourable for accepting risks from credit and duration for higher income.

Why was this period so good for high yield?

Simply put, massive monetary support from central banks pushed interest rates lower and dampened volatility, and those conditions helped to limit defaults in high yields while pushing bond prices higher. Plus, risk preferences and an aging global demographic created more demand for bonds, providing a steady bid for more speculative credit. In other words, the bet of loaning money to shaky companies worked fine in this period, given that high yield issuers were largely able to repay or refinance their debts.

Annual default rates 1920 - 2019

Source: Moody’s Investor Services, as at February 2020.

But where we stand today in the ‘New Normal’ is clearly different. Asset price volatility has increased with the more uncertain future following the Covid-19 pandemic, even with rates staying low and governments pledging fiscal support. The rapid spread of the pandemic caused a massive widening in credit spreads in March and April 2020, and a subsequent loss of capital (although a chance to reinvest at higher yields) for the sub investment grade bond market. Yet high yield does not look like a bargain anymore, with spreads recovering to pre-lockdown levels while the probability of defaults has plainly increased.

How do convertible bonds work well if conditions have become far less favourable for the high yield market?

In part, it is down to structure and convexity. That is, while high-yield bonds are a one-way bet that a speculative issuer will not default, the embedded option to convert gives positive returns if stocks rally, but limited downside thanks to a bond floor. These structural features helped convertibles to outperform high yield, both when markets sold off in early 2020, and during the rally that began in April 2020. In fact, from the year’s lows, convertibles recovered to pre-lockdown levels more quickly than high yield, and as of the end of September, convertibles are positive for the year while high yield remains negative. We would imagine that the outperformance of convertibles during this period shows the benefit of convexity and begins to place the asset class on more equal footing with high yield in terms of trailing returns.

Speculative-grade corporate default rates

Source: Moody’s Investors Services, 31st August 2020.

RWC Global Convertibles Fund

5-year performance

Source: RWC Partners, 30th September 2020.

iBoxx Global High Yield Index

5-year performance

Source: RWC Partners, 30th September 2020.

Convertibles vs High Yield

1-year performance

Source: RWC Partners, 30th September 2020.

We also see another turning point coming from issuers that are now choosing to use our market, with a record amount of convertible issuance in 2020. In a world of low rates and low volatility, issuers used the high yield markets with carefree abandon and no concern for extra leverage. Now that volatility and uncertainty have returned, simply adding another layer of debt to get through a rough patch doesn’t make as much sense. We are seeing convertibles issued by companies that may be the stronger operators in a challenged sector, and who see an opportunity to raise funding as a differentiator versus weaker peers, especially if they can convert this debt to equity.

At the same time, we continue to see companies using our market to finance growth prospects, particularly in sectors such as IT where the pandemic has created opportunities in areas such as distance working and learning. With less representation from highly leveraged or cyclical sectors, many investment grade or equivalent convertible bonds, and a growth aspect to many issuers, the sector composition of the convertible market is also quite different to high yield, with potential diversification for credit.

RWC Global Convertibles Fund
- B USD

Sector
Weight
Cash
1.46
Communication Services
10.1
Consumer Discretionary
17.6
Consumer Staples
0.98
Energy
1.41
Financials
13.19
Health Care
10.37
Industrials
7.81
Information Technology
30.48
Materials
4.36
Utilities
2.24

Source: Bloomberg, RWC Partners, 30th September 2020.

Markit iBoxx Global Developed Markets High Yield Index (GHYG US ETF)

Sector
Weight
Cash
0.3
Communication Services
19.3
Consumer Discretionary
20.1
Consumer Staples
4.8
Energy
11.8
Financials
9.4
Health Care
11.4
Industrials
6.2
Information Technology
6.8
Materials
7.5
Utilities
2.9

Source: Bloomberg, RWC Partners, 30th September 2020.

In hindsight, high yield looks great, but the future looks bleak.

Overleveraged issuers are facing conditions vastly different to those they assumed when taking on debt, and investors accustomed to low defaults from this market are thinking again about exposure to this asset class. We aren’t calling the end of the party just yet for high yield, but we do believe that convertibles can offer a viable replacement for that asset class in portfolios.

Compared with high yield, with strong bond floors and the presence of IG issuers in the convertible market, there is greater protection on the downside from the possibility of economic distress. And while corporate bonds become less valuable in theory with higher volatility and issuers have a greater potential to default, the embedded equity option in a convertible becomes more valuable because there is a greater likelihood that something good may happen. That optionality is something that high yield bonds don’t have; they either pay back, or they don’t, and the chance of not paying back seems to be rising.

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

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