Despite high yield prices currently being at all-time highs, many European investors indeed stick to the asset class as default rates are low and interest rates on higher-rated bonds are simply not high enough for many of them.
When EIE’s researchers visited Frankfurt in March, appetite for high yield among Frankfurt-based fund buyers was at all-time lows with just 11% planning to increase their allocation in the coming 12 months. Less than two months later though, demand for the asset class has tripled, possibly because of lower inflation expectations in the US and Europe.
Patrick Maldari, senior portfolio manager global high yield for Aberdeen Asset Management, and Fraser Lundie, co-head of credit for Hermes asset management, both identified a number of ways to approach the asset class.
Credit default swaps
Considering the uncertain outlook for high yield and the demanding price levels of high yield bonds, Lundie prefers to get exposure to the asset class through spread products such as credit default swaps. Maldari also uses cds’s, but ‘only to buy protection against an existing position’.
Showing a chart featuring the composition of the global high yield market over time (see figure), Maldari stressed the dominance of US high yield is quickly fading. It is therefore essential to use a global approach and a dynamic asset allocation when investing in high yield and to include emerging market local and hard currency debt in your investment universe, the Aberdeen manager stressed.
While Maldari and especially Lundie are exploiting alternative strategies in high yield, M&G’s Wolfgang Bauer, the third fixed income manager attending the conference, takes a different approach. “I am running a bond fund, not a derivatives fund.” Therefore he prefers to focus on opportunistic bets in the bond market, such as the growing yield gap between Treasuries and UK Gilts on the one hand and German Bunds on the other.
“On the short term I think Bunds have a good chance to further outperform as the ECB will possibly loosen its monetary policy, while the Fed and the BoE will tighten further.”
Inflation or deflation?
While Hermes’ Lundie admitted prospects for high yield do not look bright now, Aberdeen’s Maldari stressed inflation expectations are very low, resulting in positive real yields. Besides that, as long as real growth stays below potential in the developed world, he expects high yield prices to develop sideways.
When the room was polled about the question what they consider the greater threat, deflation or inflation, the outcome was quite surprising. While last week at Expert Investor Portugal only one fund selector was more fearful of inflation, the room in Frankfurt was split.
German citizen Bauer explained: “We Germans are a still somewhat inclined to attribute a high risk to inflation because of the traumatic experiences during the Weimar Republic, when an entire generation’s wealth was wiped out by inflation. But I don’t see a great inflation risk myself as the ECB will simply not allow it to happen.”
The other two panellists saw deflation as the clearly greater risk of the two. Maldari explained his tack by underlining that nobody in the US is expecting deflation, implying that investors’ portfolios have not been designed to weather deflation.
Considering the outcome of last week’s poll in Portugal, this is not the case in Europe. But also here, deflation risk is serious. According to Lundie, macro-risks such as the conflict with Russia escalating, might drive GDP growth lower, resulting in lower inflation. On the longer term, innovation resulting in persistently high unemployment levels and lower prices for technology-based products might lead to structurally lower inflation.
Click here to see a slideshow of photos taken at Expert Investor Germany.
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