What allocation split do you recommend between high-yield and emerging market debt?
In funds that can invest in both high-yield and emerging market bonds, we are 70% weighted toward high yield. This is not because high yield is offering better yields or higher quality investments at the moment, but because it is typically less volatile than emerging market debt, so we're getting a better risk-return ratio on high yield. This is partly due to the illiquidity of the high-yield market relative to the emerging market bond market. The average high-yield bond is about $200 million in size and compared to EM is less frequently traded. Therefore high yield tends to have less price volatility. By contrast, emerging market bonds--often around $2 billion or more in size--are very liquid and are priced on the back of the sovereign debt, which means any crisis affects a much larger part of the market and results in higher volatility.
How do you see your allocation changing in the next 12 months?
When the spread between high-yield and emerging market debt converges--as is the case at the moment--we prefer high yield because it has lower volatility. However, going forward we expect the split to shift back in favor of emerging markets as that spread widens out. We will go to a 75% maximum weighting in favor of emerging market debt after the next crisis. Admittedly, it is hard to predict when exactly that will happen.
What is your outlook for the credit cycles in high yield and emerging markets?
We expect high-yield spreads to remain range-bound for the next five years or so, while the benign economic backdrop remains in place, interest rates continue to go up and high-yield issuance picks up to meet demand. If you think of the cycle as a clock, we're at 3 p.m. and company profits are growing faster than company debt. So the cycle has yet to move through 6 p.m. (when debt growth overtakes profit growth) and 9 p.m. (when the bubble bursts) to midnight, when companies start de-leveraging again. The key at the moment is not to buy everything that comes to market. It's especially important to be selective in high-yield new issuance.
In emerging markets, crises dictate the cycle. It's impossible to say when the next one will hit us, but we are definitely closer to the next one than further from the last. That said, we expect spreads to go tighter still before they go wider, on the back of pension funds increasing their allocation to credit and a robust economic backdrop in emerging markets. One positive development in the bond markets is that they are getting better at disaggregating risk. In the Mexico crisis of 1995, 95% of the index sold off, whereas in the most recent Argentina crisis, Argentina was down but the rest of the index was up.
Where are you putting money to work in high yield?
Credit selection will be key over the next few years. Our process ensures that the fundamental research we carry out on all of our investments stresses the companies over a three-five-year cycle.
There are certain sectors we don't think are suited to high yield. Retailers and airlines both have high operating leverage, so things can fall off a cliff quite quickly on a small decline in sales. Utilities, as a highly regulated sector, can be adversely impacted by changes to the regulatory framework. And high-grade financials are tough enough to analyze, so imagine coming to grips with a sub-investment grade company.
That said, we do look at quality companies in all sectors. We invested in U.K. department store Debenhams, for example, as we like the management team and its business strategy.
And what about in emerging markets?
We like oil-exporting countries, which are facing an extended period of high revenues, and are not too keen on countries that are net oil importers. Also, bonds in this sector react hugely to political rumors and we'd avoid countries with higher political noise than average. Even if a country has gone to investment grade, politics still have a huge effect on bond prices.
In terms of regions, South America represents the best value. We like Europe as well, but it offers less value and in Asia there's hardly any money left on the table. We tend to play Europe and Asia through local currency markets, especially as individual countries become investment grade and governments focus on things like developing a domestic pension fund industry, which increases the breadth and depth of the local market.