Artisan Canvas

Finding Opportunities Amid Policy-Driven Volatility

There’s been no shortage of volatility so far this year as building inflationary pressures and increasingly tighter monetary conditions have led to spikes in volatility across interest rates and risk assets. Across credit markets, de-risking has become more common as investors price in their expectations for higher policy rates and the potential impact on global growth. Uncertainty continues to drive price action in the near term, but through the noise, growing pockets of value are emerging across the high yield landscape. For the disciplined and discerning investor, volatility is creating plenty of opportunities to capture attractive yield and alpha.

Relative Value Implications

Given the superior tradeoff between duration and yield, we’ve been less constructive on high yield bonds relative to leveraged loans over the last 18 months (as we mentioned here and here). But our relative value views have shifted more recently as high yield valuations have dramatically improved with broad rate and risk aversion. The impact of rising rates has contributed to more than half of the year’s drawdown—even more so for higher-rated and more rate-sensitive segments of the high yield market (Exhibit 1). Lately, though, growing concerns of a slowing economy have led investors to reprice their outlook for credit risk. While current spreads are elevated relative to the cyclical lows of the last two years, valuations are still below average and are nowhere near levels reached during previous slowdowns.

Exhibit 1: Cumulative Returns by Asset Class

Source: JPMorgan/ICE BofA/Bloomberg. As of 31 May 2022. Asset classes represented by the following indices: JPMorgan Leveraged Loan Index (Leveraged Loans), ICE BofA US High Yield Index (High Yield Bonds), ICE BofA US Corporate Index (IG Corporates), Bloomberg Aggregate Bond Index (Aggregate Bond) and JPM EMBI Global Diversified Index (EM Debt). Past performance is not a reliable indicator of future results.

 

The dual impact of higher rates and wider credit spreads have led to an uptick in pricing dispersion and a better set of valuations for the market as a whole. Today, the vast majority of high yield bonds are priced below par, and the percentage of the market that is call constrained is at a post financial-crisis low (Exhibit 2). Increasing our optimism for the asset class are widespread dislocations and deep dollar discounts that create attractive opportunities for convexity and total return. The market today is littered with high quality performing credits with dollar prices in the 80s, despite no material change in fundamentals. While it’s likely credit markets remain vulnerable to continued volatility and swings in sentiment, broad weakness has created opportunities to add incremental yield and total return in what we think are uniquely mispriced high yield bonds.

Exhibit 2: Widespread Discounts Characterize the High Yield Market
ICE BofA US High Yield Index: Price Distribution

Source: ICE BofA/Bloomberg/Artisan Partners. As of 31 May 2022. Based on constituents in the ICE BofA US High Yield Index.

 

Leveraged Loan Resilience Beginning to Fade

High yield underperformance comes at a time when the loan market has been largely immune to the year’s volatility. Investors have used the asset class to express their interest rate views, creating a nearly limitless bid for floating-rate structures. In turn, the loan market has been able to defy gravity for much of the year, far outperforming any other fixed income segments—particularly those with duration risk. Given the outperformance, the yield differential between high yield bonds and leveraged loans sit at multi-year highs. But shifting expectations for less aggressive tightening, combined with broader credit concerns, have led to leveraged loan underperformance over the last several weeks (Exhibit 3). While we acknowledge the positive tailwinds for the asset class remain intact, we think high yield bonds exhibit better risk/return potential than leveraged loans, especially if the current risk-off backdrop worsens.

Exhibit 3: Weakness Showing in Leveraged Loans Prices
JPMorgan Leveraged Loan Index: Average Price

 Source: JPMorgan. As of 31 May 2022. Past performance is not a reliable indicator of future results.

 

Credit Fundamentals Still Intact

Without denying some of the challenges the economy faces currently, our outlook for credit fundamentals remains solid. Corporate issuers are in a stronger position to weather a slowdown relative to cycles past. Two years of record low interest rates have allowed companies to term out their balance sheets and reduce borrowing costs. As it stands, high yield leverage is at pre-pandemic levels, interest coverage at post-crisis highs and defaults near record lows (Exhibit 4). And despite some sector-specific deterioration, earnings and profit margins remain above average, despite persistent inflationary pressures. With these positive trends in mind, it’s unlikely that we see a recession-like surge in defaults in the near term. Of course, there are still notable headwinds facing the economy—particularly continued pricing pressures, tighter monetary conditions or geopolitical uncertainty—but imminent signs of weakness are certainly not evident across our opportunity set.

Exhibit 4: Corporate Balance Sheets Are Better Positioned to Weather a Slowdown Relative to Past Cycles
ICE BofA US High Yield Index: Leverage and Interest Coverage Ratios

Source: ICE BofA. As of 31 Mar 2022. Based on constituents in the ICE BofA US High Yield Index.

 

Identifying Value Through an Active Approach

Prolonged periods of relative calm are inevitably interrupted by severe bouts of volatility and we view the turn in sentiment as a reaction to what has been nearly two years of complacency and accommodative monetary conditions. The previous backdrop characterized by a risk-on, pull-to-par price action has now transitioned to an environment of widespread dislocations and dispersion. For our credit-focused approach, we believe a wider set of valuations creates a better opportunity set for credit selection and alpha generation. Fundamentals ultimately drive returns, and our ability to assess credit risk independently can create meaningful opportunities for outperformance when opinions of market direction diverge. Ultimately, we think our approach is well-tailored to succeed in an environment like this, where discipline and careful credit selection is required.