Investors are getting over-compensated for risk in the high-yield bond market, according to Barings’ global head of public assets Martin Horne.
“This has been the most talked about recession that still hasn’t arrived that I’ve ever seen in 30 years in the financial services industry,” Horne told FSA.
“What you typically have going into recession is overleveraged retailers, overleveraged construction businesses (excluding China) and overleveraged automotive companies.”
“These don’t really exist in the market at the moment because we just haven’t had an appetite for risk and the over-exuberance of lending that can happen in a pre-recessionary period.”
Lenders have been wary of taking on risk after back-to-back uncertainties following Covid-19, supply chain issues, inflationary pressures, energy price spikes and now one of the most rapid interest-rate hiking cycles seen in decades.
As such, Horne points out that leverage conditions going into this upcoming recession (if it occurs) are significantly different to what they were going into the 2008 financial crisis and ensuing recession, for example.
He said: “In the high-yield market, the average leverage level is in the mid-threes at the moment. Going into the Lehman crisis, it would’ve been a mid-fives number, so the leverage conditions going into this are significantly different.”
Since inflation and recession risks have been on company radars since late 2021, management teams have had a long time to adjust to a weakening economic backdrop, Horne explained.
He said: “They have adjusted their inventory level. They’ve focused their capex on things that are going to save them cost. They’ve taken out non-core assets. They’ve preserved cash.”
“All of that has helped them deal with a much higher rate environment, a higher pricing environment and actually their ability to pass on margins has been pretty good.”
“That’s a long-winded way of me saying I quite like risk right now, because I think you are getting overcompensated for it.”
Horne said high-yield bonds look attractive at this point in the cycle because of both the high-income component and the potential capital appreciation.
He said: “In spite of all the events that we’ve had, it’s the income component that has kept the high yield market in such a remarkably better position.”
Despite the turmoil in the long-dated US treasury market and the volatility it has caused in the high yield market, the S&P US High Yield Corporate Bond index for example, has returned high single digit income over the past 12 months still has a yield to maturity of 9.4%.
Horne added: “The other thing about the bond market is that your entry level, given how many low coupon bonds are still out there and haven’t been refinanced yet.”
“The average price of the high yield markets about 87 pence to the pound, so what’s going to happen if you get if you hit a real recession, and they do bring rates down?”
“That average price is going to rise up because all the refinanced coupon debt that now looks subpar, because it looks worse than base rate, is going to get closer to base rate, you’re going get that capital appreciation. So I think you’re getting compensated for it at two levels.”
One concern for investors in the high-yield market is the potential for a recession induced cash crunch and defaults among the riskier corporate borrowers. However, Horne thinks that corporate balance sheets will make the upcoming default cycle manageable.
He added: “I also think because of where corporate balance sheets are, the divergence on what a hard landing and a soft-landing look like has narrowed.
“So do mild recessions worry me unduly? No, I think we’ve been through there before and that’s not a wholly frightening thing and I think you’re getting over-compensated for it today.”
