Our fund’s exposure to bonds rated B and below has rarely been lower. This part of the market is a natural hunting ground for us, given its explicit mandate to deliver high income. Yields remain higher here than in BB and above. So, why steer away from it?
There are two sides to this. One is the presence of attractive alternatives, both in outright yields and on a risk-to-reward basis. With the rise in interest rates, yields on higher quality bonds, in BB and investment grade, have been good. There is no need to chase income.
The flip-side of this positive is a concern that the yields offered on assets in the lower part of the credit quality spectrum do not justify the risks.
As shown in the chart above, our Invesco Monthly Income Plus Fund (UK) exposure to lower quality bonds has continued to fall in the past couple of quarters, despite this market segment being bolstered by improved growth data and rising hope of a soft economic landing. High yield bonds have outperformed investment grade.
Growth is good for high yield. High yield companies tend to be more indebted and so have higher debt-servicing costs relative to their earnings. This means they are more sensitive to changes in earnings. As an asset class, high yield is more correlated with equities than more rate-sensitive investment grade and government bonds.
With earnings holding up well across the corporate sector, commonly followed metrics for high yield, such as the ratio of debt to EBITDA and interest coverage, are looking healthy. Default rates and default expectations have also remained within the normal range.
My reason for concern about lower-quality credit is not that I see an immediate risk of an earnings recession. It is to do with re-financing risk.
For several years before 2022, ultra-low interest rates enabled bond issuers to finance very cheaply, with historically low coupons.
| European High Yield | USD High Yield | |
|---|---|---|
| Average coupon of new issues | Average coupon of new issues | |
| Issue year | % | % |
| 2018 | 3.75 | 6.43 |
| 2019 | 3.56 | 5.91 |
| 2020 | 3.76 | 5.55 |
| 2021 | 3.69 | 5.22 |
| 2022 | 6.44 | 7.10 |
| 2023 | 7.55 | 8.55 |
Bloomberg, May 2024
This changed in 2022. Higher interest rates meant the high yield bond market had to adjust to remain competitive. The price of these low coupon bonds fell below par and the coupons on new bonds began to rise.
New bonds have to offer a yield that is competitive with the secondary market. At current market yields, that means coupons on new bonds, issued at par, will have to be substantially higher.
The charts below compare the weighted average coupon of high yield bonds with the market yield. In both the European and the dollar markets, coupons are substantially below the yield. Unless the yield drops, issuers will have to pay more coupon to close this gap.
Spreads are not unusually high. In fact, they are well below average. As the chart below reminds us, the dominant driver of today’s higher yields are interest rates.
While interest rates remain high, high yield issuers face a re-financing challenge. According to Bank of America research, 25% of the US high yield market will be free cash flow negative if they have to carry out the next two years of re-financing at current rate expectations. In other words, these companies’ balance sheets don’t work unless the Federal Reserve cuts more than is currently priced.
Taking a step back, this environment is a little counterintuitive. Better growth conditions pose a threat to the high yield market. Higher earnings will increase the ability of corporates to service their existing debt, but if interest rate expectations stay high (in part because of better growth), then many will struggle with re-financing.
Monthly Income Plus is built on fundamental credit research and bond selection. I am wary of the re-financing risk faced by high yield and I have reduced exposure to that part of the market. But that doesn't mean I will avoid it altogether.
These risks may offer opportunities at the individual company level. High yield companies, as a whole, will have to pay more interest. Some companies will struggle in this environment.
I will be aiming to avoid them through careful credit assessment. But others will be able to manage. That a company has to pay more to its creditors is not necessarily a bad thing, especially if you’re the creditor.
We have already seen good companies coming to the market and paying coupons several percentage points higher than when they borrowed a few years ago. We’ve been happy to invest and to take those coupons.
The 2025 equities outlook is improving. Balance sheets look healthy, and many stocks are attractively valued, though geopolitical risks remain. Find out more.
Markets were relatively volatile during the quarter, with investors being pulled between the negatives of geopolitics and weaker industrial demand, and the potential benefit of lower interest rates.
Better inflation data prompted a strong start to the quarter, however, there was a sharp sell-off in August as positivity around interest rates was swamped by fears of a US recession. These fears gradually dissipated, and markets largely recovered by the end of the quarter.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Invesco Monthly Income Plus Fund (UK)
The Fund is theme-based or invests in a specific sector or a small number of sectors and/or industries. Investors should be prepared to accept a higher degree of risk than for a Fund that is more widely diversified across different sectors/industries.
The debt securities that the Fund invests in may not always make interest and other payments and nor is the solvency of the issuers guaranteed. Market conditions, such as a decrease in market liquidity, may mean that the Fund may not be able to buy or sell debt securities at their true value. These risks increase where the Fund invests in high yield, or lower credit quality, bonds.
The Fund has the ability to make use of financial derivatives (complex instruments) which may result in the Fund being leveraged and can result in large fluctuations in the value of the Fund. Leverage on certain types of transactions including derivatives may impair the Fund’s liquidity, cause it to liquidate positions at unfavourable times or otherwise cause the Fund not to achieve its intended objective. Leverage occurs when the economic exposure created by the use of derivatives is greater than the amount invested resulting in the Fund being exposed to a greater loss than the initial investment.
As the Fund has wide discretion to dynamically allocate across the debt securities spectrum and between that asset class and shares of companies, the risks relevant to the Fund will fluctuate over time, which may result in periodic changes to the Fund’s risk profile.
As one of the key objectives of the Fund is to provide income, the ongoing charge is taken from capital rather than income. This can erode capital and reduce the potential for capital growth.
The Fund may invest in contingent convertible bonds which may result in significant risk of capital loss based on certain trigger events.
The Fund’s performance may be adversely affected by variations in interest rates.
The Fund is invested in perpetual bonds (bonds without a maturity date) which may be exposed to additional liquidity risk in certain market conditions, and in particular, stressed market environments. This would have a negative impact on the value of these investments which in turn, would have a negative impact on the Fund’s performance.
Data as at 11th June 2024, unless otherwise stated.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Views and opinions are based on current market conditions and are subject to change. For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents the Supplementary Information Document, the financial reports and the Prospectus, which are available using the contact details shown.
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