Is high yield catching up to its investment grade big brother?

Gerhard notes that since 2005, on a risk-adjusted basis, both Euro and US high yield have produced solid returns compared with investment grade and the Euro Stoxx 50. He observes:

1. The average return of US high yield has been 7.6% compared with 4.3% for investment grade.

2. The return of Euro high yield has been 6.9%, compared with 2.9% for investment grade. 

3. The average return of the Euro Stoxx 50 over that time has been 7.6%².

Changing over history

Gerhard explains that over the past 20 years high yield companies have on average become much bigger. Instead of being minnows relative to their investment grade peers they are now formidable competitors, on several measures such as sales revenue and EBITDA, while yielding more. Larger high yield companies, he adds, tend to be more resilient to shocks and can better navigate macroeconomic downturns.

High yield companies’ capital structures have also developed for the better, says Gerhard.

He adds: “In the early days of high yield market, certain companies would have a predominately secured bank debt capital structure, reflected in an unsecured bond rating below the actual corporate rating. But over time as companies have grown, investors have become more comfortable to move to a predominately bond structure, reflected in an upgrade of unsecured ratings in line with corporate ratings.”

Elsewhere, Gerhard notes yields are high and spreads are tight but he says this is not an issue. “Our asset class is called ‘high yield’ not ‘high spread’,” he adds. “[Spread] is a word from the investment grade tourists when they come to our asset class. We don’t look at that [spread duration].”

Attractive features

An attractive feature of high yield, Gerhard flags, is the early call premium. When a company calls a bond early there is a premium to pay which is generally half the coupon at the first call date. Gerhard says recent higher coupons have meant higher call premiums and thus improved capital gains opportunities.

Elsewhere, Gerhard says high yield is supported by fundamentals. Notably, leverage ratios are at sensible levels, while interest coverage ratios are also solid.   

High yield has also migrated up the credit quality spectrum over the past decade, closing the gap on investment grade:

1. In euro markets, ~60% of the market is BB-rated and 10% is CCC-rated.

2. In the US, ~50% is BB-rated and 13% CCC.

3. This is a significant improvement from 2006 and 2007, when CCC-rated bonds represented more than ~20% of the market³.
 

Gerhard highlights constricted growth for this convergence: “When we have no growth or slight recession, investment grade companies tend to use leverage to improve earnings, whilst most HY companies hunker down or build a plant but using less leverage compared to good growth times. So in summary, investment grade and high yield markets are converging. The only difference is in high yield we believe you are getting paid more in credit spreads compared with investment grade.”

Why short-dated?    

Finally, Gerhard explains why a short-dated approach to high yield is preferable.  “For me to predict the cashflow for two years is pretty accurate. If you ask me to predict the cashflow for five years, it is more difficult because I don’t know what the economy is going to do or who the management will be.”

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