Khuram Sharih, Senior Fund Manager at Royal London Asset Management (RLAM), shares his outlook on the fixed income market and approach to multi-asset credit investing
(Interview took place on 22nd September 2022)
How have geopolitical issues impacted the high yield market?
Before the current geopolitical uncertainties, when exiting the Covid era, we went through a period of accelerated demand. This pent-up demand was across many industry sectors, and demonstrated weaknesses in supply chains and early signs of inflationary pressures. The geopolitical uncertainty in Europe exacerbated many of these earlier issues.
We've recently seen some inflation stability in headline figures such as energy and food but areas such as housing, rent, services, and wages inflation continues to persist and is much stickier. This will encourage the Bank of England to continue its hawkish stance and that will bring more uncertainty to the broader markets. However, the high yield market is very different from where it was in the previous cycle and is now better placed than it was in the past four or five credit cycles.
How has the high-yield market evolved over the past 20 years?
We've seen a considerable improvement in terms of the overall quality of the high yield market. 20 years ago, the market was valued well under $1 trillion, now it's almost $2.5 trillion. Back then, it was predominantly highly speculative B and CCC-rated companies, with CCC businesses somewhere between 15-17% of the overall asset class, but today is only 8-9% of the high yield market. At the same time, less speculative BB-rated companies are 60% of the high yield asset class whereas before they were 40%.
Moreover, through the global financial crisis and the Covid pandemic, we experienced ratings downgrade cycles. This resulted in fallen angels - investment grade companies whose credit ratings downgrades pushed them into the high yield market. These higher quality companies tended to come with more mature business models and deeper capital structures, have more flexibility from a credit perspective and contributed to the overall improvement in the credit quality of the high yield market. At the same time, lower rated and weaker companies defaulted and over time, exited the high yield market completely. Lastly, companies which are perhaps too small, borderline high yield issuers, or were struggling to raise capital in bond and syndicated loan markets are now being absorbed by the private credit market. Arguably you're having this indirect de-risking of the high yield market through the private credit financing.
Are you participating in new issuance or focusing more on the secondary market?
I think raising debt is going to be challenging over the short term as markets readjust to the concept of a structurally higher interest rate environment. At the same time, because so much debt has been locked in at low prices, there's no real incentive to take it out until there is a refinancing need or another catalyst.
We're focused on finding value in quality credits. Right now, it is challenging to participate in new issuance because there is a lot of opportunity in the secondary market, but at the same time, from a credit perspective, some of the new opportunities that have come to market have not met our criteria.
We don't want to be buying businesses which we believe will be fundamentally challenged going into a recessionary environment. Some of these companies' capital structures are highly leveraged with low real cash flow coverage due to adjustments to EBITDA, so we want to be careful in terms of the businesses we invest in.
The secondary market is opportunistic as well. Short duration high yield is a part of the market where we see a potentially attractive risk-return profile, both from an interest rate risk and credit risk perspective.
How can RLAM's multi-asset credit strategy help investors navigate the market?
Our multi-asset credit strategy enables you to invest in all sorts of fixed income asset classes. When we invest, we use the credit cycle framework that shows us how different assets behave as we go through the credit cycle. We use this framework to guide us to asset classes which perhaps offer the best value during the different stages of the cycle. We then conduct fundamental, bottom-up credit analysis to select the best ideas for the fund.
Source: RLAM, for illustrative purpose only.
The credit cycle framework is a function of interest rates and defaults. In a rising rates environment, where defaults are not yet increasing, we feel we're at the beginning or approaching the beginning of the late stage of the credit cycle because the default component hasn't increased yet. However, interest rates are still increasing and that means assets which are sensitive to interest rates such as investment grade have been quite volatile and have had a very challenging two years.
From our perspective, we prefer to maintain very low exposure to interest rates at this point, meaning keeping fund duration low. In general, our fund naturally doesn't have a high duration as we invest in floating rate assets which help manage that risk. Senior secured floating rate assets or asset-backed securities help to mitigate uncertainty regarding interest rate risk.
I think there's still value in high yield credit. When you look at the high yield credit curve, it's relatively flat, which means we believe the front end is fairly attractive. Given that the maturity profile of bonds and loans was actively extended during Covid to 2025 and beyond, the front end of the curve is now paying just as much as the long end of the credit curve, but you're not exposed to the interest rate risk while near-term default risk is also lower. In my opinion, you're getting very good value in short duration high yield.
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The fund is a sub-fund of Royal London Asset Management Investment Funds ICAV, an Irish collective asset-management vehicle authorised by the Central Bank of Ireland pursuant to the Irish Collective Asset-management Vehicles Act 2015 and the AIFM Regulations, and has been established as an umbrella fund with segregated liability between funds. It is not a recognised scheme under the Financial Services and Markets Act 2000. The Investment Manager is Royal London Asset Management Limited. Most of the protections provided by the UK regulatory system, and the compensation under the Financial Services Compensation Scheme, will not be available.
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Issued in October 2022 by Royal London Asset Management Limited, 55 Gracechurch Street, London, EC3V 0RL. Authorised and regulated by the Financial Conduct Authority, firm reference number 141665. A subsidiary of The Royal London Mutual Insurance Society Limited.
This post is funded by Royal London Asset Management