Multi-asset investing: making the most of High Yield

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Good value asset classes are hard to find right now. And after some hefty price falls over the last year, leading to much wider spreads over Government Bonds, High Yield (HY) is starting to look like a compelling choice for multi-asset investors.

But High Yield can come with high risks, and you need a robust analytical process to time your entry into this market well. Our own strategists team’s Cycle Value and Sentiment (CVS) approach helps show the way to make the most of the opportunities in HY, and to mitigate the chances of being burned by the risks.

Our view on High yield can best be characterized as modestly positive with an intention to gradually add to our current overweight in multi-asset portfolios, either on further price weakness or on an improvement in the outlook for the business cycle. The reasons behind this stance can best be summarized by looking at our investment process and the scoring of our three building blocks: Value, Cycle and Sentiment. These scores show a numerical set of relative preferences between asset classes and their individual geographic markets, and provide our multi-asset portfolio managers with a hierarchy of asset class views expressed in relative terms. This gives them a clear dashboard to compare e.g. equity versus bonds, Japan versus US equities, or HY versus Investment Grade.

Crucially, CVS is both value and time-dependent. Value is the most important long-term driver of markets, however the impact of value is moderated over the medium term by the state of the business cycle and over the shorter term by investor sentiment, which we evaluate by a mix of momentum and other technical measures.
Hence the output from CVS blends these three different inputs to arrive at a composite score for the respective asset classes/markets. For our longer-term horizon, value predominates in the scoring mix. For medium and shorter-term views, cycle and sentiment factors become increasingly more important. Here’s how CVS scores HY right now:

  • Value: With the option adjusted spread at around 800bps* we consider HY to be cheap. To be exact, we are scoring HY value at +1 on a scale of -2 to +2 with an interval of 0.5. That means we do not consider HY to be super cheap. The reason we are not scoring value higher than +1 is that after we correct for the rating levels in the index (and therefore indirectly the default probability) the spread comes down significantly. In other words, after we correct for the large amount of highly stressed CCC bonds in the index the overall spread looks less attractive. Also, we take into consideration that the effective yield on the index is still only average in a historical context. Should the option adjusted spread widen further to about 900bps we are likely to increase our value score to +1.5 and a spread above 1000bps will likely push our score up to +2. In the context of our overall process that would probably mean we would add to our overweight position.
  • Cycle: The cycle score for HY is currently negative at -0.5. We are cautious on the cyclical outlook for HY for several reasons. First, growth is cooling down and profitability is declining. This has a negative impact on the ability of companies to service their debt. Second, the credit cycle is rolling over with banks in the US in particular tightening lending standards. Historically that is a very reliable harbinger of higher default rates. Third, the downward pressure on commodity prices is expected to persist well into 2016 putting a lot of pressure on two large sectors in the HY universe, namely energy and mining. Fourth, the risks around liquidity are elevated and large ETF funds could cause a negative feedback loop to take hold in the asset class if prices continue to weaken.
  • Sentiment: Our sentiment score is a combination of momentum and contrarian signals. At the moment, we have a positive overall sentiment score because negative momentum is compensated by the oversold contrarian indicators. So, our sentiment score is telling us that momentum has overshot to the downside.

Taking the above into consideration and looking ahead at the rest of the year we are expecting to further add to our HY positions on further price weakness should it occur. Such weakness would push our value and sentiment scores up, allowing us to gradually build a position while recognizing the risk the business cycle is posing. Should we become more positive on the business cycle itself, for instance in the case of more monetary stimulus, we would add more aggressively because the cyclical headwind would turn into a tailwind.

Our actual allocation will depend on how macroeconomic and market events unfold over the course of the year. By adhering to our CVS process we aim to make the most of HY, and to avoid increasing our exposure to an apparently cheap asset class prematurely.

*As of February 18 on the Bank of America Merrill Lynch Global High Yield Index

Wouter Sturkenboom, Senior Investment Strategist, Portfolio Strategy Group, EMEA

Wouter Sturkenboom

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