High yield: floating rates to combat inflation

 

At first glance, inflationary periods are hardly the time to invest in high-yield bonds, i.e., those rated below BBB-. Since last year, broad-based increases in prices has forced central banks into more hawkish monetary policies. And higher interest rates lower the value of bonds in the portfolio.

Even so, by following our investment guidelines we think we were able to preserve our clients’ capital last year in this asset class.

First of all, as their name suggests, high-yield bonds offer greater real remuneration than investment grade corporate bonds (i.e., rated from AAA to BBB-) or government bonds. By definition, and all other things being equal, they therefore offer greater protection against inflation.

Several components

Moreover, the high yield market has several segments: fixed-rate bonds, sustainable bonds, and floating-rate notes (FRNs). In a dynamic allocation, each of these can be called upon, depending on the circumstances.

While fixed-rate and sustainable bonds were being undermined by the inflationary environment, FRNs reduced our exposure to higher interest rates and helped us consolidate our portfolio during most of last year. It being understood that the best time to buy an FRN is at the start of a tightening cycle.

As the tightening cycles of the ECB and the Bank of England are less far along than the Fed’s, this approach still makes sense today for bonds denominated in euros and sterling. Especially as we expect tightening to last longer in Europe than in the US.

True, the timing is not as good for dollar-denominated FRNs, judging by the market consensus, which is now pricing in just one or two new rate hikes in the US. While disinflation indeed appears to have begun, we cannot rule out excesses in investor anticipations. For example, they have almost ignored the January jobs report and its evidence of ongoing robustness on the labour market.

An unexpected correction

Of course, if the Ukrainian crisis were to ease or even be resolved by this summer, as some experts predict, that would help low energy and food prices. Nonetheless, the risk of inflation’s lasting longer than expected and, hence, of an unexpected correction on the fixed-income markets has probably been underestimated.

I might add that the inversion of the yield curve is a good time for investing in short-dated securities, rather than long-term bonds, which are less well remunerated.

In addition to the protection that it offers against higher interest rates, euro-denominated high-yield FRNs currently offer arbitrage opportunities linked to credit spreads.

According to the Bank of America index, spreads can be as high as 408 basis points on fixed-rate bonds, vs. 623 for FRNs. This 200bp-plus spread reflects an average yield of 8.6% for FRNs vs. 6.7 % for fixed-rate bonds. This is enough to offer solid inflation protection for two or three years.

Default risk

This inefficiency, which I expect to be resorbed soon, results from the massive inflows into the fixed-rate market in recent months from exchange-traded funds (ETFs). FRN spreads are also likely to be squeezed by debt funds and collateralised loan obligations (CLOs), due to needs to rebalance asset-liability management. 

That being said, whether you prefer fixed rates or floating rates, the greatest threat to the corporate bond market remains credit quality and defaults. That’s why we tend to overweight sectors that have the greatest pricing power, such as food retailing.

We are far more cautious on real estate, a heavily indebted sector and in which we expect defaults this year, particularly in Europe. The same goes for consumer discretionaries, such as travel & leisure, owing to reduced purchasing power. If energy prices remain very high, there are also likely to be many setbacks in the chemicals sector.