M&G (Lux) Global Floating Rate High Yield Fund - High yield FRNs: where next as the rate hike cycle peaks

• High yield floating rate notes (FRNs) have delivered strong returns year-to-date, despite the wider sell-off in sovereign bonds amid macroeconomic and policy uncertainty. In our view, their floating rate nature means that HY FRNs should continue to benefit from any further rate rises ahead of the peak of the monetary tightening cycle.
• Spreads on HY FRNs remain wider than those on traditional high yield instruments, offering the potential for further tightening as the technical factors that have caused this differential unwind. HY FRNs offer an attractive way of taking advantage of continuing yield curve inversion, in our view.
• The fund is overweight the more defensive and less cyclical parts of the market; we believe our highly experienced team of fund managers and credit analysts makes us well positioned in the event of an economic downturn.

The value of investments will fluctuate, which will cause prices to fall as well as rise. There is no guarantee the fund will achieve its objective, and you may not get back the original amount you invested. Where performance is mentioned, past performance is not a guide to future performance.

HY FRNs and the rate hike cycle

While the jury remains out for now on whether we have reached the peak of the current interest rate hiking cycle, it is clear that it is close. So far, 2023 has been characterised by increasing fears of a recession and markets trying to call the end of monetary policy tightening. Against this backdrop, high yield floating rate notes (HY FRNs) have continued to deliver strong returns (see Figure 1), in a year when sovereign bond yields have continued to sell off amid macroeconomic and policy uncertainty.

Past performance is not a guide to future performance

Figure 1: Fixed income asset class performance, year to date

Source: Bloomberg, ICE Bank of America, JP Morgan, 30 September 2023. *ICE Spain, Italy, Germany government index. US ICE Treasury & agency index, ICE UK Gilt index. ICE European currency HY index. US ICE high yield index. ICE Euro corporate & pfandbrief index. ICE corporate index. JPM EM $ JPM EMBI global diversified index. EM $ corp JPM CEMBI broad diversified composite index. JPM GBI-EM LCY global composite unhedged USD. Spot rate. World currency ranker. Stoxx 600 price index Eur. S&P 500 index. MSCI EM index

Regardless of whether central banks opt in favour of a few final interest rate increases, we believe HY FRNs should benefit from any further tightening, thanks to their floating rate coupons.

At the same time, while credit spreads have come in from peak wide levels, spreads on HY FRNs are still relatively cheaper than those on traditional high yield due to a several technical factors, while our base case scenario remains for a mild future default cycle.

These factors, coupled with the ongoing inversion of the yield curve, mean that prospects for HY FRNs, in our view, remain attractive. Below we look at what is driving each of these in more detail.

Past performance is not a guide to future performance

Figure 2: FRN and short-dated bonds offer attractive carry for income seekers, as yield curves have inverted

Source: Bloomberg. Global government bond yield curves as at 30 September 2023.

What’s driving the HY FRN market

Yield curve inversion

The continued inversion of most government yield curves (yield curve inversion has taken place because short-term yields have risen much faster than longer-term ones, reflecting investor demand for shorter vs longer-term government bonds) means that short-dated instruments such as FRNs give investors the highest carry (see Figure 2, above). A carry trade involves borrowing at a lower interest rate in order to invest in instruments that pay a higher interest rate.

This inversion has been caused by central banks’ hiking of interest rates coupled with market volatility. Today, FRNs can deliver a yield advantage of more than 100 basis points relative to longer-dated bonds. The latter also carry heavier duration risk (exposure to changes in interest rates) than their shorter-dated counterparts.

As we think about the end of the current hiking cycle, the risk-reward profile of HY FRNs remains compelling, in our view, because interest rates are likely to stay elevated for longer than previously expected. Recent hawkish comments from the US Federal Reserve, combined with continued strength in the US economy and labour market, lend weight to the argument that rate cuts are still some way off.

Technical factors are crucial for spreads

In our view, spread levels for traditional high yield bonds (currently in the low 400bps) look fairly priced to reflect our core expectation of a soft landing for the US economy. They are significantly tighter than in 2022.

However, within the wider high yield space, spreads on FRNs remain relatively cheaper, at around 600bps (see Figure 3). This difference has been driven mainly by technical factors within the market. Supply and demand dynamics are crucial here: while FRN supply has been stable, demand from collateralised loan obligation (CLO) structures and loan funds (typically important buyers of FRNs) has been lower. CLO issuance has been gaining traction in 2023, which should stimulate demand for HY FRNs. Should this trend continue, then we would expect to see spreads on HY FRNs tighten further, which should potentially translate into positive spread performance for the asset class.

Figure 3: Global high yield markets – spread valuation

Source: Bloomberg, ICE Bank of America Indices 30 September 2023. Information is subject to change is not a guarantee of future results.

Global HY FRN: ICE BoA Global High Yield Floating Rate Loan (3% Constrained) Index. Europe HY: ICE BoA European High Yield Index. Global HY: ICE BoA Global High Yield Index. US HY: ICE BoA US High Yield Index.

Capital protection versus potential default cycle

High yield corporate issuer fundamentals have, so far, held up reasonably well. This is largely thanks to buoyant consumption and pre-emptive corporate refinancings that have enabled issuers to lengthen their maturity profile at attractive rates.

Nevertheless, as developed economies slow and the impact of higher interest rates starts biting into corporate balance sheets, we would expect to see an uptick in default rates.

Our base case scenario remains that of a mild default cycle (this would result in a global default rate of c. 3-4%, in our view) which would be consistent with a soft landing. In our view, this would not be too damaging for the corporate sector. However, should default rates increase more aggressively, the fact that HY FRNs are typically categorised as senior-secured in the capital structure can help mitigate capital downside.

Fund activity

Since the start of the hiking cycle in 2022, the M&G (Lux) Global Floating Rate High Yield Fund has outperformed the major fixed income asset classes, with returns above 10%. The fund has delivered strong performance year-to-date too (over 10% in USD, 8.7% in EUR as at the end of September).

The fund is positioned to seek to generate returns through a combination of carry, improving market technicals (which in our view should prove positive for spreads) and defensive active views.

From a sector perspective, we maintain our focus on more defensive and less cyclical parts of the market, such as food producers and distributors, and software and/or online business companies. Conversely, we maintain zero exposure to banking and real estate.

With attention turning to the likelihood of impending recession, fundamental credit research will prove critical to capital preservation. In our view, our highly experienced team of fund managers and credit analysts are well placed to demonstrate the value that active management can deliver in such an environment.

M&G (Lux) Global Floating Rate High Yield Fund

Fund description

The fund aims to provide a combination of capital growth and income to deliver a return that is higher than that of the global floating rate high yield bond market -- as measured by the BofA Merrill Lynch Global Floating Rate High Yield Index (3% constrained) USD Hedged -- over any five-year period. At least 70% of the fund is invested in high yield floating rate notes (FRNs), focusing on FRNs issued by companies with a low credit rating, which typically pay higher levels of interest to compensate investors for the greater risk of default. Part of the fund may be invested in other fixed income assets, such as government bonds. Asset exposure is gained through physical holdings and the use of derivatives.

Past performance is not a guide to future performance.

Fund performance