Active management ever more important in high yield
Allocating to high yield still makes sense but investors must ensure that the philosophy and track records of their managers match their own requirements
High yield has had a fantastic run and many investors and advisers are starting to question whether there is still a good case to be made for holding high yield in client portfolios. The yield on the global high yield market (see chart below) declined from a record high of almost 23 per cent in late-2008 to a record low of just above 5 per cent in May of this year. More recently the yield has gone back above 6 per cent on the back of ‘taper-talk’ from the Federal Reserve.
The reasons for investing in high yield include the following: to provide income, to boost the yield of one’s fixed income portfolio, to diversify one’s fixed income portfolio, to make capital gains, to reduce volatility if allocating away from equity.
We believe these reasons still stand with the possible exception of ability to generate capital gains. While there will be opportunities on a name by name basis to generate capital gains, there is limited scope at the market level, given yields are close to record lows and, as it seems likely, US Treasury yields have bottomed.
Although yields are low and there is talk of Fed tapering, we still see many headwinds for the global economy and so believe rate hikes are some way off. In this continued low growth, low yield, low default environment we expect high yield to remain well supported by retail and institutional investors seeking income/yield and by pension funds allocating from equities to high yield as they de-risk.
During the huge rally over the last few years, there was strong growth in the ETF (exchange traded fund) market and this was, for many, an efficient way of getting exposure to a rallying market with improving fundamentals. However, going forward as we get later in the credit cycle and as yields are much lower, we believe an active approach to the market is called for. It is now more about ‘coupon clipping’ – collecting your coupon income and avoiding defaults – than capturing large market moves. In this environment it is important to have a very strong manager or, ideally, combination of managers who can navigate the market and avoid default losses.
When selecting managers, be they global or regional, the first thing to understand is manager style and habitat so one knows how their return pattern should vary in different market environments. This helps to identify the style of manager one may want and also to review their performance after one has hired them.
We divide the manager universe on three principal planes:
• Quality: There are managers who have a high quality focus (BB/B). Some favour lower quality (B/CCC) and then others cover the whole rating spectrum and rotate as and when they see opportunity
• Default approach: There are conservative managers that seek to avoid all defaults and others who seek to exert control in default situations to realise value
• Market cap: Some managers (often the larger ones) prefer the liquidity of large-cap issuers, while others prefer to hold less liquid, less well researched names which can offer more active management opportunity
Having classified managers, one then needs to identify the best managers. We recommend assessing a manager’s investment philosophy – what market inefficiencies are they seeking to exploit? Then assess their investment team and process to see if they have the ability to capture those inefficiencies in a repeatable fashion. Another important area to focus on is risk management and portfolio construction. Make sure you understand how diversified their portfolios are and what the maximum position size is.
Product capacity is another area that deserves attention. Market liquidity has worsened considerably since the financial crisis and so it is key to assess whether a manager can easily react to changes in view on a name or market sentiment.
In summary, high yield still has a lot to offer but with yields low it has become increasingly important to select the right active managers. Given the importance of avoiding defaults and the broad range of styles out there, we think it makes sense to adopt an active multi-manager approach.
James Mitchell CFA, Portfolio Manager, Russell Investments
