The case for HY FRNs as the hiking cycle approaches its peak

7 min read 31 May 23

By M&G Wholesale Public Fixed Income team

High yield floating rate notes (FRNs) demonstrated their value in 2022, when their effective lack of duration risk shielded them from the worst of the bond market sell-off. They have continued to deliver solid returns year-to-date in 2023.
In recent weeks, we have started to see the market price in expectations that interest rates will stay high for longer than previously expected, which in our view should be supportive for high yield assets in the medium term.
There are a number of reasons to remain positive on prospects for HY FRNs: they offer an attractive way to take advantage of inverted yield curves while offering a zero capital loss should rates remain volatile. Furthermore, spread levels remain above historical averages, while pricing in a higher rate of default than that seen either historically or in our base-case scenario for this cycle.

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.

Positive prospects for HY FRNs

Throughout much of the last 18 months, high yield floating rate notes (HY FRNs) have offered investors protection from the worst of the bond market ravages caused by sharply tightening monetary policy in response to rocketing inflation. So far in 2023, the asset class has continued to deliver solid returns, with the asset class outperforming other major high yield bond markets year-to-date as a result of their lack of duration risk and higher levels of income (see Fig 1).

While expectations for further rate hikes at this point in the cycle are now significantly more muted, any further potential monetary policy tightening should benefit HY FRNs, thanks to their floating rate coupons. At the same time, credit spreads on the asset class remain relatively wide, despite stronger company balance sheets than in previous recessions, in our view, and an analyst consensus of a mild future default cycle.

As such, we believe there are a number of reasons to remain positive on prospects for HY FRNs in the coming months. We highlight three of these below.

Past performance is not a guide to future performance

Fig 1. HY FRNs have offered protection from rate hikes

Source: ICE Bank of America Indices, 30 April 2023. Index performance shown 100% hedged to USD. Information is subject to change and is not a guarantee of future results.

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

Past performance is not a guide to future performance

Fig 2. FRN and short-dated bonds offer attractive carry for income seekers

Reasons to be cheerful

Taking advantage of the yield curve

Firstly, FRNs and short-dated credit offer an attractive way to take advantage of what remains of both an inverted and elevated yield curve (yield curve inversion takes place when the longer term yields falls much faster than short term yields, reflecting investor demand for longer vs shorter term government bonds). With three-month Euribor yielding c. 1% higher than 10-year bunds at the moment, HY FRNs provide a yield advantage for investors whilst offering a zero capital loss should interest rates remain volatile.

The HY FRN index is currently yielding around 9.7% in euro terms and around 11.4% in US dollar terms, being one of few fixed income asset classes that can provide a decent level of positive real (inflation-adjusted) income in an environment of moderating but still significantly above-target inflation.

In recent weeks, we have started to see the market price in expectations that interest rates will stay high for longer than previously expected, which in our view should be supportive for high yield assets in the medium term.

Attractive valuation

Secondly, while credit spreads for the asset class (which indicated the difference with government bond yields) have tightened in recent weeks, they remain above historic averages. In our view, current spread levels (645bp) are overpricing default risk. Assuming a 60% recovery rate, current valuation equates to a 5-year implied default rate of 9-11% annually. This level of default risk is significantly higher compared to the historical default rate for the asset class, which is c. 3.5% over the same period.

Enhanced protection versus default risk

Our base-case scenario is for a mild default cycle. There are various reasons for this that include: more resilient corporate fundamentals, a higher quality high yield universe today than in previous economic cycles, as well as relatively contained levels of market distress observed so far.

If, however, the default cycle should prove more aggressive than our base case suggests, the senior-secured nature of the asset class can help mitigate capital downside. For reference, HY FRNs have a recovery potential of between 60% and 80%; this compares to more traditional high yield recovery levels of closer to 25%.

Fund positioning

Within the fund, we currently prefer physical HY FRNs to their synthetic equivalents, with the former making up around 80% of our exposure. There are two main reasons for this: firstly, the primary market is seeing heightened activity as companies are starting to refinance their 2024 maturities and new issues are coming to market at attractive terms.

Secondly, from a relative value perspective, we prefer to take advantage of the spread dislocation that currently exists between physical FRNs and fixed rate high yield issues. We do retain some credit default swap (CDS) exposure, which currently stands at around 10%, to maintain sufficient liquidity within the fund.

From a sector perspective, we are focused on the more defensive and less cyclical parts of the market such as food producers and distributors, and software and/or online business companies. In the case of the former, demand for their services is broadly constant; for the latter, their online offering means they are relatively less exposed to input costs and wage rises than their physical peers.

We do not currently have exposure to banks. The main index constituents are Italian banks ranked outside of the country’s largest five players by assets, for example Monte dei Paschi di Siena, Mediobanca and Banca IFIS, which we do not currently find attractive from a risk/reward perspective.

Our other focus is on identifying names that are trading at low cash prices for idiosyncratic reasons and offer upside potential. One example is online betting business 888 Holdings. Recent regulatory changes in the UK aimed at improving consumer protection and reducing problem gambling saw the issuer’s bonds drop to mid-80s levels in late 2022. Having topped up our position, the price has now recovered and is now trading in the 90s.

With spread dispersion growing within the high yield space, fundamental credit research will prove critical to capital preservation as the year progresses. 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

Return (%)	Year to latest quarter	YTD	1 Yr pa	3 Yrs pa	5 Yrs pa	10 yrs pa
Fund EUR A-H Acc	3.6	4.4	3.2	6.9	1.1	N/A
Benchmark (EUR)*	3.8	4.6	3.7	8.7	3.1	N/A
Fund USD A Acc	4.3	5.3	6.1	8.7	3.3	N/A
Benchmark (USD)*	4.4	5.5	6.5	10.4	5.2	N/A

Return (%)	2013	2014	2015	2016	2017	2018	2019	2020	2021	2022
Fund EUR A-H Acc	N/A	N/A	-0.4	6.5	1.6	-2.6	4.3	-0.8	4.5	-3.3
Benchmark (EUR)*	N/A	2.1	-0.7	11.1	2.7	-1.3	6.8	2.0	6.6	-2.2
Fund USD A Acc	N/A	N/A	0.1	7.8	3.7	0.2	7.4	1.0	5.4	-1.1
Benchmark (USD)*	N/A	2.2	-.02	12.7	4.8	1.5	10.0	3.6	7.4	0.0

*Benchmark: BofA Merrill Lynch Global Floating Rate High Yield Index (3% constrained) USD Hedged Index. Benchmark prior to 01 April 2016 is the ICE BofAML Global Floating Rate High Yield (EUR Hedged) Index. Thereafter, it is the ICE BofAML Global Floating Rate High Yield 3% Constrained (EUR Hedged) Index.

The benchmark is a comparator against which the fund’s performance can be measured. The index has been chosen as the fund’s benchmark as it best reflects the scope of the fund’s investment policy. The benchmark is used solely to measure the fund’s performance and does not constrain the fund's portfolio construction.

The fund is actively managed. The investment manager has complete freedom in choosing which investments to buy, hold and sell in the fund. The fund’s holdings may deviate significantly from the benchmark’s constituents.

Fund performance prior to 21 September 2018 is that of the EUR Class A-H Accumulation of the M&G Global Floating Rate High Yield Fund (a UK-authorised OEIC), which merged into this fund on 7 December 2018. Tax rates and charges may differ.

Source: Morningstar, Inc and M&G, as at 30 April 2023. Returns are calculated on a price-to-price basis with income reinvested. Benchmark returns stated in EUR terms.

Key fund risks

Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.
High yield bonds usually carry greater risk that the bond issuers may not be able to pay interest or return the capital.
The fund may use derivatives to profit from an expected rise or fall in the value of an asset. Should the asset’s value vary in an unexpected way, the fund will incur a loss. The fund’s use of derivatives may be extensive and exceed the value of its assets (leverage). This has the effect of magnifying the size of losses and gains, resulting in greater fluctuations in the value of the fund.
Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.
The fund is exposed to different currencies. Derivatives are used to minimise, but may not always eliminate, the impact of movements in currency exchange rates.
The hedging process seeks to minimise, but cannot eliminate, the effect of movements in exchange rates on the performance of the hedged share class. Hedging also limits the ability to gain from favourable movements in exchange rates.

Further details of the risks that apply to the fund can be found in the fund’s Prospectus.

Other important information

The fund allows for the extensive use of derivatives.

Investing in this fund means acquiring units or shares in a fund, and not in a given underlying asset such as a building or shares of a company, as these are only the underlying assets owned by the fund.