Why invest in high yield floating rate notes today? M&G (Lux) Global Floating Rate High Yield Fund

• Global high yield floating rate notes (FRNs) delivered strong returns in 2023, during a period of significant macroeconomic uncertainty. 2024 has begun in a very different vein, characterised by falling inflation, the prospect of monetary policy easing and cautious optimism that a soft landing may be achieved.
• We believe that this environment remains favourable for the HY FRN asset class. A combination of high all-in-yields, continuing inversion at the front end of sovereign yield curves, attractive spread levels, and relatively low default rates mean that HY FRNs are positioned to deliver solid returns in 2024, in our view.
• From a positioning perspective, we maintain our focus on the less cyclical parts of the market, and are particularly cautious on zero interest-rate model businesses, which may struggle in the next phase of the economic 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.

The case for HY FRNs

While the case for investing in floating rate notes in an environment of rising interest rates is obvious, there are a number of reasons why we believe HY FRNs continue to look attractive in today’s environment. We highlight three of these below.

Firstly, many government yield curves remain inverted (yield curve inversion had originally taken place because short-term yields had risen much faster than longer-term ones, reflecting investor demand for shorter vs longer-term government bonds). FRNs are the best way to exploit this yield advantage on offer at the front end of sovereign yield curves. A carry trade involves borrowing at a lower interest rate in order to invest in instruments that pay a higher interest rate.

Secondly, spreads levels on HY FRNs continue to be higher than those of traditional high yield instruments. At the end of February, the option-adjusted-spread for global HY FRNs stood at 453bps on average, versus 350bps for the global high yield market (and even tighter for US HY). Technical factors are the main cause of this ongoing difference: specifically, supply and demand dynamics. 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 began to pick up in 2023 and if this trend continues as we expect, then we believe HY FRN spreads will likely tighten further, potentially translating into positive spread performance for the asset class.

Finally, markets are cautiously optimistic over the prospect of a soft landing as we enter the next phase of the economic cycle. While high yield corporate issuer fundamentals have held up reasonably well to date, we would expect to see an uptick in default rates as economies begin to slow. Our base case scenario remains that of a mild default cycle (this would result in a global default rate of c. 3-4%), 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, with higher potential recoveries, can help mitigate capital downside.

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