6 min read 29 Jan 19
Summary: As we all know, 2018 turned out to be a tough year for most asset classes, not least High Yield (HY) bonds. The sell-off in the fourth quarter was particularly quick and brutal compared to the recent lulls of benign volatility under the blanket of central bank largesse. Global HY lost a few percentage points in pure local currency terms in 2018, whilst the lower beta and more senior secured heavy Floating Rate Note (FRN) market held up a little better with a loss of just under 1%. This was a timely reminder that the HY FRN market (which shares many risk characteristics with the senior loan market, including its senior secured nature and floating coupon) is typically less volatile than conventional fixed rate HY bonds in periods of market corrections.
Where does that leave investors looking at 2019? Should they favour floating rate or fixed rate HY?
To try and answer this question, I’ve outlined below some total return scenarios based on different changes in spreads and interest rates. These scenarios also take into account an estimate of one-year currency hedging costs in order to give a fully hedged return. I have assumed a 1.5% default rate, with an average recovery rate of 30% for the fixed HY market and a higher 60% for the floating market. I am also assuming that any change in yields is purely a steepening / flattening move, meaning that there are no further rate hikes over the following 12 months. See below the 3 scenarios – for fully hedged US, Euro and UK-denominated FRNs and HY bonds.
What can we infer from the above?
Given the relative strength of the US and global economy, a return of QE is quite unlikely – in my view, this should give an edge to FRNs in most likely return scenarios. I do have to caveat that this is based on several assumptions, so should be taken as theoretical. Also, there are other variables that would also have an impact, including FRN’s lack of capital upside, as they trade close to par, and any increase in default rates above 1.5%.
Having said that, the inherent resilience of FRNs, through their low spread and interest rate duration, could be a good tailwind for the asset class in 2019. This could well be a good year for floating rate High Yield.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.