Q. How have recent geopolitical and macroeconomic issues impacted the high yield market?
Investors can almost demarcate the recent environment by two different periods: the Covid-19 pandemic and the war in Ukraine.
The Covid period was defining because it was such a direct crisis that resulted in overwhelming monetary, fiscal, and shareholder support. These actions suppressed credit spreads, which meant that many corporate issuers were able to extend their maturities in that period at a very, very low cost of capital. The Ukraine war ended that first period because the war drove up energy prices and inflation.
Q. Many high yield companies took advantage of historically low rates in 2020 to refinance. When do you expect these companies to have to come back to the market and what challenges may they face?
Most of these issuers had extended their debt before that period, so the transmission of this higher cost of capital was relatively muted. Although we had some volatility in credit spreads as investors initially took fright, high yield fundamentals were well supported and that has resulted in a very moderate default climate until now.
We expect that most high yield issuers will wait for interest rates to recede from their relatively high levels before returning to tap markets. They are relatively comfortable with the position that credit spreads are not going to be too volatile, and they have a good handle on the strength of their balance sheets.
Equally over the last few months, we've seen credit spreads tighten quite considerably compared to the previous 12 to 18 months. Issuers have started to return to the market and they are able to be proactive because the cost of capital is reasonable.
Q. What's activity been like in the primary market and are you seeing the most attractive markets in the primary or secondary market?
Issuance post Ukraine fell substantially, so we saw primary markets recede dramatically in 2022 and 2023. We had only a combined $370bn of issuance in those two years compared to $1tr in the two years before that. That was driven by a fall on the supply side so there weren't many maturities, and there's been a bit of a log jam in the leveraged buyout market as valuations haven't fallen while capital costs have been higher.
On the demand side, private credit has started to play a role in financing riskier parts of the high yield market. As a result, secondary markets have been far more interesting than primary markets. In secondary markets, almost the entire high yield market trades at a discount to par. That is very unusual in a benign environment and we find the opportunity particularly compelling here.
Q. Are any segments particularly exposed should rates remain higher than current expectations?
The high yield market has institutionalised considerably over the last 15 years. This means that within the credit rating segments, it is now more BB heavy, rather than B or CCC heavy. With the attractive yields on offer for strong, liquid BB and B credits, that's more than sufficient to soak up natural public market demand.
That means that the CCCs and those smaller issuers are far more exposed to a higher rate environment. Some of those capital structures really aren't sustainable at current yield levels and certainly won't be funded by public markets.
Now at the same time, we do think this part of the market is very small and there is a lot of dry powder in private markets, which is willing to step in to fund some of these issuers. We don't think this is going to spark a serious increase in default rates, but it is certainly going to be a little bit different from the past.
Q. How do you look to promote active ESG integration into strategies such as your multi asset credit solution?
We've spent a lot of time bringing our funds into compliance with the Article 8 status under SFDR. Our policy factors in the tension that can exist with a bad ESG credit that is actually creditworthy. In our view, only considering the ESG risk intrinsic in the credit is insufficient. For example, a high carbon emitter may have a low amount of debt, so it is a strong credit with a negative ESG profile.
The way we factor it in our policy is two-fold. First, we consider those intrinsic risks which are ESG risks as well, and these impact the creditworthiness of the investment.
Second, we think about the ESG impact of issuers on their environment. We try to mitigate that impact by engaging with those companies as much as possible. What we are trying to do is ultimately cultivate portfolios which have more positive externalities than the broader market.
Q. How can Royal London Asset Management's multi asset credit strategy help investors navigate the current market?
Our approach is based on harvesting the income found in credit and protecting against the downside risk of credit losses. This means we use diversified sources of income across different credit streams, exploit market inefficiencies, and ultimately provide a solution which we believe has more certainty than more traditional credit investing. For pension investors, this is a simplified growth asset with a relatively short duration; and we think that greater certainty of income allows for better planning.
Azhar Hussain is Head of Global Credit, Royal London Asset Management. To find out more about Royal London Asset Management's range of investment solutions please visit www.rlam.com
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Issued in April 2024 by Royal London Asset Management Limited, 80 Fenchurch Street, London, EC3M 4BY. Authorised and regulated by the Financial Conduct Authority, firm reference number 141665. A subsidiary of The Royal London Mutual Insurance Society Limited.
