High Yield FRNs in 2025: Keep Calm and ‘Carry’ On – M&G (Lux) Global Floating Rate High Yield Fund

^{Source: Bloomberg, 28 November 2024.}

Government bonds have been to some extent weighed down by political uncertainty and rising government debt (the US debt-to-GDP ratio hit 123% in 2024, according to US Treasury Fiscal Data in November 2024), leading to losses for some investors in long-term debt. On the other hand, high yield (HY) corporate bonds have been one of the most resilient assets during the year. Among these, high yield floating rate notes (HY FRNs) delivered another strong year of performance. 

Their lack of duration (sensitivity to changes in interest rates) and healthy income (a result of their variable coupons linked to short-term reference rates) have helped HY FRNs record a year without any negative month of return (to end-November 2024) for the first time in the history of the asset class.

As the chart in Figure 2, below, illustrates, the global HY FRN market has recorded a return almost similar to that of the traditional HY market, but has done so with lower volatility, providing a smoother return journey to investors. 

Figure 2: Global high yield markets have shown robust year-to-date returns

Past performance is not a guide to future performance

^{Source: ICE BofA Indices, 30 November 2024. Index performance shown 100% hedged to USD. Information is subject to change and is not a guarantee of future results. Global HY: ICE BofA Global High Yield Index. Global HY FRN: ICE BofA Global Floating Rate High Yield 3% Constrained (USD Hedged) Index. US HY: ICE BofA US High Yield Index. Europe HY: ICE BofA European High Yield Index.}

Outlook for 2025: keep calm and ‘carry’ on

Year-to-date (as at the end of November 2024 according to Bloomberg data), global HY FRNs have delivered returns of more than 9.0% in USD terms/7.5% in EUR terms, meeting our expectation of a year ago.

Turning to the coming 12 months, if we assume our base case scenario of a soft landing, there is the potential for further solid returns (see green square within the charts in Figure 3, overleaf). In this scenario, while debt and interest metrics may deteriorate modestly, high yield fundamentals would remain resilient and high yield issuers could benefit from lower interest rates.

A combination of carry¹, expected low defaults and reasonably strong corporate balance sheets will be the main drivers of these returns. It’s worth noting (top right corner of Figure 3, overleaf) that HY FRNs could potentially prove relatively resilient in more adverse scenarios involving sharper spread widening.

Figure 3: How might the strategy perform over the next 12 months?

For illustration purposes only. This is not intended to provide expectations of future returns or yield and spread levels. Portfolio analysis based on a one-year holding period, assuming a static portfolio and parallel shifts in yield curves; excludes any exposure to equities. Analysis also assumes that any moves in rates and/or spreads are one-off shocks. Assumption of a 3% default rate with an average recovery of 60% for the floating high yield market and 30% for the global fixed high yield market. Source: M&G, ICE BofA, 27 November 2024.

The fund’s base currency is the US dollar. Investors in the euro-denominated share classes will be exposed to changes in eurozone interest rates regardless of which underlying currencies the portfolio is invested in, due to currency hedging and to the principle of covered interest rate parity (CIRP) -- the market principle that underpins currency hedging and interest rates. According to CIRP, cross currency exchange rates quoted in the forward markets must reflect changes in interest rates between the two currencies over that same period, in order to prevent arbitrage opportunities and limitless risk-free gains in the markets.

More broadly, we think 2025 should shape up to be another positive year for high yield markets, albeit with returns more likely to be driven by carry. While credit spreads are currently close to the tighter (lower) end of their range, all-in-yields for HY bonds remain higher that they’ve been in previous years. Historically, yield has been a good proxy of future returns, and with current yields around 5-7%, we believe there is arguably still potential for the asset class to generate reasonable returns in 2025.  

Another potential tailwind reveals itself when taking a closer look at recent new issuance levels (see Figure 4, overleaf). While gross issuance activity has been relatively similar to what we have experienced for the last 15 years, most of it has come from companies proactively refinancing their existing liabilities. As a result, net issuance (ie gross issuance minus redemptions during the same period) has been lower in recent years.

At the same time, the broader high yield market continues to shrink as an increasing amount of capital has flown into other parts of the leveraged finance markets (ie issuers seeking capital in the leveraged loan or the private credit market). This, coupled with low levels of new issuance and the ongoing need for income, creates a supply/demand imbalance which could potentially become a powerful tailwind for the asset class going into 2025, in our opinion. 

Figure 4: Strong demand meets lower net issuance

^{Source: Bank of America, Barclays, 28 November 2024}

Finally, despite macro and political uncertainty, recent economic performance has shown continued strength, with corporate profits and consumer spending remaining largely resilient in the face of high interest rates. It’s worth noting that the interest coverage ratio (which measures a company’s ability to pay off its debt), while dropping as companies have refinanced at higher rates, remains well above levels at which analysts would typically become concerned about companies’ ability to pay.

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 economic landing. This is also evidenced by diminishing levels of market distress (see Figure 5), which is typically a good leading indicator for default activity over the next 12-18 months. 

Figure 5: US and European high yield default cycles; the ratio of distressed issuers tends to lead default cycles

^{Source: ICE BofA, 30 November 2024. Default rate calculated as last 12 months par weighted default rate. Distress is defined as spreads > 1,000bp. Information is subject to change and not a guarantee of future results.
US HY: ICE BofA US High Yield Index. Europe HY: ICE BofA European High Yield Index.}

In our view, a mild default cycle 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 a company’s capital structure, with higher potential recoveries, can help mitigate capital downside.

In summary, even with moderating growth, we see potential for the asset class to generate reasonable returns in 2025, given the power of carry, expected low defaults, reasonably strong corporate balance sheets and lower rate volatility.

Taking advantage of our team’s experience

While passive investments have seen rapid growth in recent years, we believe there are several crucial advantages for choosing active management when investing in high yield. This is especially true in the current climate, as uncertainty over the future path of interest rates and inflation continues to drive heightened volatility across markets.

M&G’s high yield team has grown in the 10 years since the strategy’s launch. Today, we manage more than US$15bn across dedicated HY strategies, flexible strategies, and segregated mandates. Our core high yield fund management team has an average of 20 years of experience investing in high yield markets.

Our global footprint has also expanded significantly in recent years. Our fund managers work alongside one of the largest and most experienced global credit analysis teams, including more than 50 sector-specialist analysts based in London, Chicago, and Singapore.

This global footprint means we have research coverage of 98% of European high yield, 80% of US high yield and around 50% of Asian high yield markets*. We believe that our depth of investment experience, combined with this global research capability, allows us to identify and take advantage of market mis-pricings across the global high yield spectrum.

We take a prudent approach to managing the portfolio, with a focus on enhancing liquidity and reducing return volatility for investors. Our process relies on detailed bottom-up credit analysis of individual issuers and issues, and our approach is to avoid the more distressed and volatile parts of the market.

*50% of the representative index, JACI, which currently has around 555 issuers, including both IG and HY.

Fund description and positioning²

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 ICE BofA 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 high yield companies, 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 primarily through physical holdings. Derivatives may also be used.

The fund’s focus is on generating active return through credit selection whilst preserving an enhanced liquidity profile and avoiding the more pernicious downside of a hard default cycle, by being well diversified and more conservatively positioned than its benchmark.

Currently, we have the highest exposure to physical assets in the strategy’s history, because we think the valuation of physical HY FRN assets is more rewarding. Furthermore, an active primary market has continued to provide opportunities to lock in some additional spread premia, whilst adding further diversification into the portfolio.

Most of our use of derivatives is for liquidity management purposes. We have around 10% of the fund invested in the CDX High Yield index, a financial index made of credit default swaps (CDS) issued by North American companies. CDS indices are typically very liquid instruments, which can also provide additional diversification benefits to a portfolio.

In terms of sectors, the fund is more conservatively positioned than the benchmark, with a strategic underweight to higher beta (more cyclical) and distressed sectors in order to seek to preserve a lower volatility profile compared with the benchmark.

We are currently actively underweight in sectors like financial services, where various issuers still face refinancing issues, or banking, where issued bonds are typically not senior secured assets.

A quick look at fund performance

Past performance is not a guide to future performance.

Fund performance

*Benchmark: ICE BofA Global Floating Rate High Yield Index (3% constrained) USD Hedged Index. For the EUR share class, benchmark prior to 01 April 2016 is the ICE BofA Global Floating Rate High Yield (EUR Hedged) Index. Thereafter, it is the ICE BofA Global Floating Rate High Yield 3% Constrained (EUR Hedged) Index. For the USD share class, benchmark prior to 01 April 2016 is the ICE BofA Global Floating Rate High Yield (USD Hedged) Index. Thereafter, it is the ICE BofA Global Floating Rate High Yield 3% Constrained (USD 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 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 November 2024. Returns are calculated on a price-to-price basis, net of fees, with income reinvested. Benchmark returns stated in EUR and USD terms respectively. Performance data does not take account of the commissions and costs that may incur on the issue and redemption of units. Not all share classes registered for sale in all countries. Details in Prospectus.

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

Other important information

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.

For explanation of the terms used in this document, please refer to the glossary on our website:

https://www.mandg.com/dam/global/shared/en/documents/glossary-master-en.pdf

The views expressed in this document should not be taken as a recommendation, advice or forecast.

¹Here, carry refers to the income received by bondholders from regular coupon payments.
²Source for all positioning data: M&G, as at 30 November 2024.