Markets in brief
2022 has had a very volatile start as a hawkish Federal Reserve
(Fed), inflation, margin pressures and Russia’s invasion of Ukraine
have caused risk assets to sell off.
Using the ICE BofA US High Yield Constrained Index the first quarter was the tenth worst return quarter on record for the high yield market, as yields climbed higher with rising Treasury rates while credit spreads only widened modestly; higher quality, longer duration bonds led the declines for the quarter.
However, during the second quarter spreads weakened as inflationary prints remained elevated and fears of slowing global growth percolated, led by China’s renewed lockdowns, and lower quality underperformed within high yield.
Energy has been one of the few bright spots, as economic sanctions against Russia pushed commodity prices higher as demand outpaces supply.
Outlook and challenges
Going forward, all eyes will remain on the Fed and their ability to execute a ‘soft-landing’ while raising interest rates and implementing quantitative tightening.
Specific to high yield, the market has entered this period from a position of strength: leverage is low, interest coverage ratios are high, and revenue and EBITDAs have mostly surpassed pre-COVID levels.
Even with the significant repricing move through the first half of the year, there is limited distressed debt in the market, implying a low default environment for the next 12-18 months.
Following back-to-back years of record issuance, the high yield maturity wall was extended, with only 6% of the market set to mature in the next two years, resulting in the low year-to-date issuance.
As we look to the third quarter, we expect spreads and yields to remain range bound, generating a modestly positive return for the quarter.
Opportunities
The high yield market once again offers positive convexity following the move lower in bond prices. High yield bonds are now trading at a significant discount to par, implying capital appreciation will contribute more to total return than it has in recent years.
We are finding value in higher quality, low coupon bonds that were issued late last year and now have a price in the $80’s. We initially passed on these issues, but they look attractive now with the discounted dollar prices.
We still do not believe investors are being compensated for taking on cyclical risk and are finding better value in more stable sectors such as healthcare and communications.
Consumer facing sectors, such as leisure/lodging, transportation and energy, are poised to perform well throughout the summer but will need to successfully forecast slowing demand and rising input costs as the year comes to a close.
We remain slightly shorter in rate duration relative to the benchmark (ICE BofA US Cash Pay High Yield Index (CAD)), although as duration has increased, we have extended and are closer to the benchmark than we were to begin the year.
Volatility has been elevated in 2022 and will likely remain elevated throughout the year as the Fed is challenged with combating inflation without slowing down the economy.
While we think the market will move sideways, there will be opportunities for active management to outperform as security dispersion will increase.
Breakevens for the asset class have increased, implying the market can generate a positive return even if rates increase another 150bps.
Given the healthy underlying fundamentals and increased yield for the asset class, we believe this is an attractive entry point for long term investors who can withstand short term volatility.
Fund strategy
The investment strategy is driven by fundamental research and bottom-up security selection, with no quality nor duration bias. The strategy seeks to identify undervalued securities in the marketplace through fundamental research and relative value analysis, with an emphasis on downside protection.
This flexible approach allows the strategy to shift exposures in response to changing market conditions and is designed to generate excess returns in both up-and-down markets.
