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Friday 29 March 2024

Following the closure of the Third Avenue fund earlier this month, liquidity issues are once again at the forefront of investor’s minds when it comes to the high yield market. Ultimately, conditions will only improve with structural changes to the market but in the meantime we think there are several steps that can be taken to help improve the underlying liquidity profile of a high yield portfolio.

Buy and Hold – by keeping portfolio churn low and buying securities with a view to a long term holding period and accepting that there will be some price volatility, the liquidity needs of a portfolio are automatically curtailed. This also means corporate fundamentals and the underlying credit worthiness of an issuer over the long term are bought more sharply into focus at the point any purchase is made. The question “Would I be happy to hold this bond through periods of market distress” is a good one to ask. If the answer is “yes”, then the chances of finding a buyer during such periods are greatly enhanced.

Stick to larger bond issues – The bigger the bond issue, the greater the investor base and the greater chance of being able to match a buyer and a seller (we illustrate this below by comparing the recorded activity trade activity for a $4.28bn bond, and a $200m bond issued by the same company). However, this can be a double-edged sword. The larger a bond issue, the more likely it is to be a constituent of an ETF portfolio which can be disadvantageous during periods of large redemptions.

December 17th 2015 Trade History for Sprint 7.875% 2023, $4.28bn outstanding:

Trade History for Sprint 7.875% 2023

December 17th 2015 Trade History for Sprint 9.25% 2022, $200m outstanding:

Trade History for Sprint 9.25% 2022

Diversify by market – Trading environments can and often do differ in different markets. A portfolio that can invest across the range of ABS, financials, corporate, sovereigns, emerging markets, fixed rate or floating rate, Europe or the US can often exploit better liquidity conditions in one market when another is facing difficulty.

Use liquid proxies – The daily volume that trades in the synthetic CDS index market is an order of magnitude greater than the physical cash market. Keeping part of a portfolio in such instruments provides access to a deeper pool of liquidity and can provide a useful buffer in periods when the physical market conditions worsen. However, there is an opportunity cost in terms of stock selection that needs to be considered.

Liquidity in euro credit is more than 10 times higher in indices

Keep cash balances higher – The most effective way to boost liquidity in a portfolio is the simplest: hold more cash. 5% is the new 2%. Again, there are opportunity costs in terms of market exposure and stock selection, but the benefits in terms of liquidity are immediate and tangible.

It’s important to stress that none of these measures are a silver bullet, but they are mitigants. They can buy time and help investors tap liquidity. In today’s high yield markets, the question of how a portfolio’s liquidity is managed has become just as important (if not more so) than its investment position.

As the year draws to a close, 2015 has actually been a solid if unspectacular one for the European High Yield market. Total returns of a little under 3%* compare well to negative returns in the US and Global High Yield markets. European default rates also continue to trend lower, hitting 0.14% for the last twelve months to the end of November according to data from Bank of America Merrill Lynch. All good then?

Well, not really. The overall numbers look ok but this masks some dramatic pockets of weakness within the market. Several bonds have seen some large losses. The most notable perhaps being an 86% price drop by bonds issued by Abengoa SA, the Spanish renewables company. This has not been an isolated incident either. Investing in this environment brings to mind an iconic scene in “The Matrix”, when Neo, the main character, survives a sustained hail of bullets by effectively dodging them. He takes a few marginal hits but the point is he survives by ducking the more dangerous, fatal projectiles. Likewise, a successful 2015 for most European high yield investors has been defined in similar terms: you’ve had a good year if you dodged most of the bullets.

So where has the damage been done?  In the table below, we show the worst performing bond issuers this year in percentage terms. For the sake of simplicity, where there are multiple bonds issued by the same company, we have simply included only the worst performing amongst them.

Bullet dodging – European high yield in 2015

From the above, we can draw out a few themes. The big losses have been experienced in the following situations:

  1. Engineering companies with complex funding needs and emerging market exposure
  2. Brazilian corporate issuers
  3. Any company that has significant exposure to falling energy prices
  4. Steel makers
  5. Struggling retailers

Indeed, I think it’s fair to say much of the recent weakness in the US high market has been driven by many of the same factors (not least the moves in the energy and commodity related space). The difference is that exposures to some of the poorer performing sectors are comparatively much higher in the US, so the overall impact is more meaningful.

What I think is interesting here is that this shows the European market has not been immune to such forces and investors still need to be cognisant of the risks, particularly as the market has held up so well this year.  Bullet dodging, therefore, is still likely to be a useful skill going into 2016.
Bullet dodging – European high yield in 2015

*Total return of +2.8% year to December 9th, BofA Merrill Lynch European Currency HY Index

Following another sell off, the US high yield market has once again touched the psychologically important 8% yield level today. This is an important valuation signal that has helped to tempt investors back into the market in recent months. However, the last move up in yields has been driven in part by a renewed downdraft in commodity prices, not least with WTI pricing in the low $40’s. Energy issuers make up a not insignificant 12.7% of the US high yield market so such moves cannot be easily shrugged off. Hence, the most common rejoinder to any assertion that “US high yield is cheap” when yields hit these levels, is that it’s “cheap for a reason”.

Is there a way around this? Can investors benefit from headline yields in the high single digits without taking on the heightened commodity risk of buying the bonds of financially levered oil and gas producers?

Well the short answer is “kind of”. You can benefit from high single digit yields, but not without some compromise. Here are 4 potential ways to do it:

    1. Go “Commodity Free” – This would be a portfolio that excludes both the Energy, Steel and the Metals & Mining sectors (as defined by BofA Merrill Lynch), which together account for 17.5% of the market, but holds a proportionately equally weighted amount of whatever remains. The all in yield for such a portfolio would be roughly 6.8% with the 2 largest sectors being Banking and Telecommunications.
    2. Go “Commodity Lite” – How about a portfolio that gave you a 50% weighting to the Energy, Steel and the Metals & Mining sectors (i.e. a more manageable 8.7% combined weighting)? This would produce a yield of 7.5% today – a comparatively smaller give-up to the 8.0% market head line yield. This would probably suit investors who feel that a lot is already priced into credit spreads in the commodity related sectors.
Yield % of US HY Market
US High Yield 8.0% 100%
US High Yield Energy 12.3% 12.7%
US High Yield Steel 10.8% 1.6%
US High Yield Metals & Mining 14.8% 3.2%

Source: BofA Merrill Lynch, Bloomberg

    1. Leverage up – if the 8% yield target is sacrosanct, this can be achieved by using a moderate amount of leverage on a “Commodity Free” US High Yield portfolio. A gross exposure of 116% would be required to make up the yield shortfall (before taking into account the cost of any funding). A “Commodity Lite” portfolio would require a more manageable 106% gross exposure. However, for good reason, many investors are unable or unwilling to employ leverage in their portfolios (including us).
    2. Use Longer Dated Bonds – if capturing the potential upside from tighter spreads (and the associated capital gain) was the priority, one way to keep pace with a market rally but without commodity exposure would be to buy a longer dated non commodity portfolio. The US high yield market has a credit spread duration of 4.1 years (i.e. for every 100bps of spread move, there is roughly a 4.1% capital impact). When we adjust for differences in spread levels between sectors, we think a “Commodity Free” portfolio with 4.9 years of credit spread duration would capture the same upside assuming a proportional move in credit spreads across the market. The same number for a “Commodity Lite” portfolio would be 4.4 years. The downside here is that spread duration is difficult to separate from interest rate duration and hence there would also be more exposure to moves in the treasury yield curve with this strategy.

As is so often the case, there is no free lunch here – if investors want the 8% yields on offer, they have to be exposed to the more volatile sectors and take on associated default risks. Nevertheless, as we can see from the above, there are several ways in which relatively attractive yields can be achieved whilst minimising some of the underlying commodity risk.

We have seen a fairly swift and deep sell off in both commodities and emerging market equities over the past few months. The recent moves are now feeding through into a more broad-based sell off in risk assets. It appears an opportune time to take stock and see how exposed the various high yield markets are to these trends.

In order to assess any impact, I will firstly consider direct exposure, defined as the proportion of the market that is emerging market domiciled (i.e. exposure to the potential double whammy of both a slow-down in growth and a currency depreciation) or those parts of the market that are engaged in the commodity space (defined as issuers within the energy, mining and steel sectors). Secondly I will look at indirect exposure, or to put it another way, how vulnerable the respective high yield markets could be to a more general re-pricing of risk given the differences in terms of duration, credit rating and capital structure.  For the sake of brevity I will use four broad indices (all published by Bank of America Merrill Lynch), the US High Yield Index, the European Currency High Yield Index, the High Yield Emerging Markets Corporate Plus Index (a hard currency index) and the Global Floating Rate High Yield Index. This is by no means exhaustive and there are instances of overlap between them but when trying to consider the broad outlines of the US, European, EM hard currency and Floating Rate high yield markets we see them as reasonable proxies.

High yield market direct exposure

Exposure of HY indices to emerging markets

By definition the Emerging Market index is the most exposed, but what is perhaps more interesting is the relative exposure within other markets. The US High Yield market has very little direct exposure but due to a difference in index rules, emerging market issuers issuing in European currencies are eligible for inclusion in the European high yield index with the same being true for the Floating Rate index. Hence there is a comparatively higher level of direct exposure, albeit it’s still fairly limited in absolute terms at 11% and13% respectively.

Exposure of HY indices to commodities

In terms of direct commodity exposure, the Emerging Market index is the most exposed with 34% of the market classified within energy, metals and mining or steel. The US market follows with 18% exposure given and the Floating Rate market is close behind at 17%. The European market is far less exposed at a little under 9%.

High yield market indirect exposure

The key metric to consider when looking at the exposure to broader market moves for credit indices is spread duration. Broadly defined this is the capital loss in % for every 1% move in credit spreads. So assuming all credit markets traded 100bps wider, the US High Yield Market would see a capital loss of approximately 4.1%. Of course, this sort of move is never uniform but on this measure both the US market and the European markets have more credit risk “beta” than the EM High Yield market and the most defensive is the Floating Rate high yield market with only 2.4 years of spread duration.

Interest rate duration (effective duration below) should also not be ignored. Credit spreads and government bond yields have historically maintained an inverse relationship (albeit less so in the era of quantitative easing).  Accordingly a flight to quality that pushes down government bond yields should help lower some of the price volatility caused by spread moves. The exception to this is the Floating Rate market which has very limited interest rate duration – short term price moves are almost entirely driven by credit spreads alone. Nevertheless, we would expect spread moves to dominate any move in the government bond market when it comes to the high yield markets, hence the focus on spread duration.

HY indices: key characteristics

How about differences in credit risk? The chart below shows that in terms of rating the highest quality market on this measure is in fact the EM index with the European market very closely behind.  Both the US and Floating Rate markets have a higher proportion of B rated bonds relative to less risky BB bonds. However, we should also consider capital structure differences as this can have a big impact in terms of credit losses during a default. On this measure the Floating Rate market is the most defensive with just under half the index classified as “senior secured” whereas both the US and EM markets are dominated by “unsecured” bonds which rank lower in terms of creditor preference and so are perceived by the market to be more risky.

HY indices: credit ratings

 

HY indices: capital structure

Bringing it all together, when we consider all the factors above, the European high yield market is probably the least exposed fundamentally to both commodity and emerging market risk and indeed is the least risky in terms of credit rating. However, in terms of capital structure and credit “beta” (spread duration), the Floating Rate market is the most defensive.  Accordingly it shouldn’t come as a huge surprise that the European and the floating rate markets have held up relatively well during this sell off as shown in the below chart. Consequently, any major further weakness in either the Floating Rate or European market due to an emerging market or commodity related correction could be an interesting opportunity.

HY indices: total returns

Turning to US and EM markets, with its well-publicised exposure to shale credits, the US market has already taken some pain following the correction in WTI prices as we have previously written about. Nevertheless, when we look at the fundamentals we need to remember it is still dominated by both domestic and non-commodity related issuers –this is where the more interesting value is starting to emerge. In contrast, it could be argued that the EM market looks vulnerable given it has seen a very similar price dynamic but with far more fundamental risk when it comes to domestic emerging market economies and indeed with more exposure to commodity related sectors.

We’ve written in the past about some of the concerns we have over the gradual weakening of bond covenants (the legal language that protects the right of bondholders) over the past few years. However, today we have seen a real world instance of a bond covenant kicking in to the benefit of existing holders, namely the change of control. This illustrates how and why such covenants can help protect the interests of investors.

It was announced this morning that Lowell Group, a specialty financial services business in the UK, will merge with a German competitor. As part of the deal there will be a change of ownership. Consequently, the “change of control” language will be triggered. This gives the bondholder the right but not the obligation to sell back the bonds to the company at a price of 101% of face value.

The company’s GBP 5.875% 2019 bonds have been trading below this level since mid-2014. Following today’s news we can see in the chart below that the price has risen up by a little over 3% to this 101 level. As the new combined business will be more financially leveraged, it is fair to say that without this covenant the bonds would most likely have fallen in price to reflect the increased credit risk of the combined entity. This clearly demonstrates the economic value that this covenant can have.

2015-08 blog JT

We’ve seen a swift and rapid re-pricing of the bund curve in recent weeks, highlighting again the risk to capital that bond investors face when yields start to rise. All major bond markets in Europe have been impacted to some degree. Nevertheless one corner of the bond market has remained very resilient: floating rate notes.

We have highlighted before how these instruments have some potentially useful features in a rising yield environment, most notably a very low sensitivity to moves in government bond markets. To put it another way, a bond with little or no interest rate duration has been a good bond to hold over the past few weeks.

We can see this in action by looking at two bonds recently issued by the Swiss mobile phone business Salt (formerly known as Orange Switzerland). The company refinanced its debt in April, issuing four different bonds. The two of interest here are identical in many ways – they are both denominated in euros, both are senior secured instruments, both have the same maturity date – except for one very important difference: one has a fixed 3.875% coupon, the other has a variable coupon that resets every three months to the prevailing three – month EURIBOR rate plus a fixed margin of 3.75%.

Both instruments have the same credit risk associated with them (the risk that Salt defaults on its debt obligations), but the move from a fixed coupon to a floating coupon drastically changes the bond’s sensitivity to moves in the wider government bond market (this is the interest rate duration number in the table above – it drops from almost six years, to close to zero). The impact of this small but important difference can be seen in the relative price performance of the bonds in the month following their issue.

As we can see, the floating rate bond has effectively been immune to the move in the bund market, and in fact it has traded up by around 1%. In contrast the fixed rate bonds have suffered and seen a 2% capital loss. This difference in interest rate sensitivity has meant a 3% relative differential in capital return over the space of just a few weeks.

We can see that in recent weeks floating rate bonds issued by companies have been well worth their salt.

Full disclosure: M&G funds own bonds issued by Salt

Picture the scene: a meeting room, 40 floors up, plate glass floor-to-ceiling windows with views of central London in the background. At the polished mahogany table sits Hans Schmidt, the CFO of a major consumer global goods company. In walks Chad “Ace” Jefferson III, the latest in a long line of investment bankers assigned to cover his company. Behind Chad follows an entourage of five impeccably dressed junior bankers, whose sole purpose seems to be to carry Chad’s presentation packs.

“Hans! Buddy! High five!” Chad almost shouts as he bounds across the room with his hand raised.

Hans looks at him blankly, refusing to reciprocate the vulgar greeting. Instead he gets up and offers a handshake.

“Hello Mr. Jefferson,” he mumbles, already slightly irritated.

“I love you Swiss guys, so formal! It’s awesome!” says Chad beaming widely, shaking his hand.

“Yes, well, I agreed to this meeting because you said you had a once in a generation opportunity for our business Chad, if you don’t mind, let’s get on with this yes.”

“Alriiiight! Let’s get to it.” Chad turns to one of his entourage. “Jean-Philippe” he barks, “Get your ass in gear, give Herr Schmidt a presentation, chop chop!”

“OK so I’ll cut to the chase,” he says, pushing aside the presentation that Jean-Phillippe had worked on until 4am that morning. “Now that the ECB has finally got with the programme and done some good ‘ol fashioned QE, a good chunk of the European government bond market is now trading at negative yields. This means the scope for funding your business on the cheap is better than ever my friend. Here’s the thing …”

Chad leans towards Hans and almost inaudibly delivers his killer blow.

“With our help, your company, Hans, could issue a bond with no cost to the company.”  Chad leaps to his feet and starts pacing around.

“I’m talking no coupon Hans! Free money! No interest rate! This is a thing of beauty. Think about it, a €500m bond issued at zero cost of financing.  We can re-finance a big chunk of your debt and reduce the interest costs to zero. This baby feeds straight to the bottom line. I’m talking major EPS benefits buddy. Your board will love you for it Hans. It’s a no brainer!  BOOM!”  To emphasise his point, Chad slam-dunks the presentation into a nearby bin, causing Jean-Phillippe to wince.

Hans turns to Chad and says, “OK, so you have my attention. This sounds interesting. But why would any investor buy my company’s bonds without a positive coupon? Does that not defeat the whole point of a corporate bond?“

“Great question Hans! It’s a case of choosing the lesser of two evils here. If you are a bond investor, buying a corporate bond from a respected company like yours for zero return, it may well be a better option than buying a government bond with a guaranteed negative return to maturity. You still get a positive credit spread after all. Also, if you think we are going to experience deflation in the Eurozone, a zero return in nominal terms still means a positive real return, either way, you are better off – crazy I know, but true!”

Chad finishes and sits down, smiling even more broadly than before, supressing the urge to punch the air.

Fin

Now, I hasten to point out that all of the above is total (and poorly written) fiction, but we may be getting closer to the point where such conversations are possible.

In his daily note to investors on 4th Feb, Jim Reid at Deutsche bank pointed out that Nestlé’s EUR 2016 bond closed at a yield of negative 0.002%.

The market is essentially sending out an unprecedented pricing signal to highly rated corporate issuers. It’s saying “we will not demand a nominal positive return for lending you money.”

The immediate consequence of this is a further reduction in potential funding costs for short term debt, particularly for investment grade companies.  This could lead to yet another round of financing cost efficiencies. Additionally, we may even see zero yield short term corporate bonds being issued for the first time – a brave new world indeed.

“Hail Caesar, those who are about to die salute you” may well have been the gladiatorial epitaph of choice two millennia ago, but the junior creditors of Caesar’s Entertainment Operating Co are unlikely to feel the same way.

In 2008, TPG and Apollo Global Management, two powerhouses of the private equity industry, led a $30.7bn buyout of Harrah’s Entertainment Inc, the US gaming business. This was one of a wave of large LBOs at the time that was fuelled by the availability of cheap financing. Almost immediately, the debt-laden group began to struggle as the US economy stuttered and with a high debt burden, the group was unable to invest in new growth areas such as Macao. Seven years later, the group’s principal shareholders and secured creditors have bowed to the inevitable, agreeing to implement a large debt restructuring sometime early in 2015*.

Much like the TXU bankruptcy in 2014, the Caesar’s restructuring will see a wide range of outcomes for its bondholders. Partly, this is due to the inherent complexity of the capital structure (see chart below). There are 3 main issuing entities (Caesar’s Entertainment Operating Co, Caesar’s Entertainment Resort Properties, and Caesar’s Growth Properties) and it should be noted the proposed restructuring will focus on only one of the entities (Caesar’s Entertainment Operating Co). The capital structure is a product of a range of re-financings, asset swaps, equity issues and other layers of financial engineering over the years.

Caesar’s Corporate Structure

Also, within each issuing entity, there are distinct layers of seniority for various bonds, ranging from 1st lien through to unsecured claims. If we look at where a few of the more liquid bond issues are trading, we can see that the expected recoveries vary from close to par (i.e. next to no impact) for some bonds backed by direct senior claims over a range of properties, to around 12 cents in the dollar for some of the unsecured bonds.

Bond prices: Caesar's and related entities

As the restructuring end-game came closer in 2014, the different position in the capital structure was also reflected in the price performance of the bonds. The unsecured claims, whilst already trading at distressed levels at the start of 2013, saw a further market-to-market loss of around 75% over the following 2 years.

Bond prices: Caesar's and related entities

This is another default that illustrates the potential downside risk of investing in a highly levered company. However, what the Caesar’s case also shows us is how some of the inherent asymmetry of corporate bond investing (big downside risk to capital with limited upside) can be mitigated by focusing on the more senior instruments within a capital structure. Consequently, the important question bond investors should ask themselves is not necessarily “if” they should lend to a company, but “where” in a capital structure they should put their money at risk.

Full Disclosure: M&G is a holder of Caesar’s Entertainment Resort Properties bonds.

*NB – this is still subject to gaining approval from other creditors and the US courts.

One of the many unintended consequences of structurally low interest rates over the past few years has been the emergence of mini-bonds in the UK. These are typically non-tradable debt instruments issued by companies directly to individual investors*. We’ve commented before on one such bond issued by Chilango, a London based vendor of Mexican food, and highlighted some of the risks relative to the more established institutional bond market (very limited disclosure, an absence of legal covenants, lack of call option protection and no secondary market liquidity).

Nonetheless, these instruments are proving to be popular, not least given the interest rates on offer, but also due to some of the more exotic features such as coupons in the form of goods and services. Indeed, the latest addition to the pack is Taylor Street Baristas, who are offering a bond with the choice of an 8% cash coupon or 12% store credit.

The question always intrigues us – who are buying these bonds? Looking at some of the mini bonds issued over the past 3 years and some of the non-cash coupons on offer, we can build up an interesting profile of the quintessential “mini bond” investor.

Some recent mini bonds

When we consider the above, this is the profile that starts to emerge:

Location – London – the food selection on offer (Taylor St Baristas, Chilango and Leon) is only of any practical use to someone who lives and works in London and can access the relevant branches on a regular basis. Until such time as these chains expand outside the capital, our quintessential mini bond buyer is almost certainly a Londoner.

Holidays – South West – the combination of the River Cottage discount (with branches mainly in the West Country) and the Mr & Mrs Smith credit means our mini bond buyer is well incentivised to spend any down-time in a boutique hotel in the South West of England.

Diet – PoorWhilst the River Cottage and Leon may offer food at the healthier end of the spectrum, the weekly burrito, fine coffee, lots of chocolate and a steady supply of wine suggests an indulgent lifestyle.

Hobbies – Cricket / HorseracingThe numerous Jockey Club venues offer up a range of opportunities for a day at the races peppered with the odd trip up to Old Trafford.

Without going as far as saying that mini bonds are targeted at obese London based oenophiles who occasionally venture out to Newmarket, there is a more serious point to be made when we look beyond the gimmicky features of this market.

A new source of finance for businesses at a time when bank lending conditions are difficult is something to be welcomed. What we would not want, however, is this to come at the expense of investor protections for bondholders. These protections have evolved over several decades in the institutional bond market and serve an important function in protecting investor rights and indeed their capital. These protections really matter when things go wrong and we are yet to see any default in this particular market so this deficiency is yet to manifest itself.

With this in mind this is what we would like to see in any future mini-bond :

  1. Call option protection – if an issuer wants to redeem a bond earlier than the stated maturity (the so called issuer call option), the investor should receive a premium to the face value of the bond to offset the loss of potential coupon.
  2. Adequate financial disclosure – Historical audited accounts including full balance sheet, cash flow statement and profit and loss must be disclosed and a commitment made to update investors with new accounts on a timely basis.
  3. Explicit security and/or collateral over the assets of the business – in the event of a default, the ranking of the bond in the capital structure should be made explicit with reference to any assets on the balance sheet.
  4. Equity participation/return – in the absence of any security or collateral, if an issuer wishes to raise finance for an aggressive expansion, it is only fair that an investor who risks their capital shares in the upside either through a high coupon or an element of equity participation.
  5. Restrictions on payments and leverage – the ability for the company to strip cash out in the form of dividends at the expense of bondholders should be explicitly limited as well as the ability to raise additional amounts of debt that pose a risk to existing creditors.
  6. Transferability – the option to buy or sell a bond to a 3rd party before maturity would greatly enhance an investor’s ability to manage their risk and their exposure.

With these additional features in place, mini-bond holders would begin to share some of the beneficial features of the institutional market whilst at the same time allowing them to enjoy the more exotic coupons on offer. Otherwise, even with the extra wine and burritos, mini bond investors are getting a raw deal compared to the more established corporate bond markets.

*NB – this is in parallel to the development of the more regulated retail bond market that has emerged in the UK, Italy and Germany where issuers are subject to more stringent oversight and the bonds themselves are listed on an exchange and are transferable.

We are entering a new era for interest rates in the developed world. The extended period of ever looser monetary policy is starting to draw to a close. In the wake of the tapering of quantitative easing (QE) from the Federal Reserve (Fed), investors now expect to see the first interest rate hikes in many years, initially in the UK and shortly afterwards in the US. The principal focus of the debate is over the questions of “when?” and “how fast?” interest rates should rise, not “if?”. For bond investors in particular, this transition has thrown up a lot of difficult questions. Having benefited greatly from falling yields and tightening credit spreads, the move to a more hawkish cycle will create many more headwinds and challenges when it comes to delivering returns for many fixed income asset classes.

Consequently, any instrument that can help investors navigate this environment has rightly been receiving a lot of interest and attention. In the latest in our series of the M&G Panoramic Outlook, we will focus on one such instrument, the high yield floating rate bond. In recent years, this instrument has gained popularity with many issuers and the market has grown to a total US$44 billion.

A high yield floating rate note (FRN) has two key defining features: (1) a floating rate coupon that is automatically adjusted in line with changes in interest rates; (2) a relatively high credit spread that reflects the additional credit risk of a non-investment grade issuer.

It is the combination of these two features which not only enables investors to receive an attractive income stream now, but also allows them to benefit from higher coupons should interest rates increase with no associated loss to capital. This last element, the lack of a hit to capital in a rising interest rate environment, is the key difference to the traditional universe of fixed coupon bonds which suffer from price declines as yields move up.

In this issue, we will take an in-depth look at the characteristics and make-up of the high yield floating rate bond market. We will also consider the key drivers of returns, as well as some of the risks and how these can be managed.

Author: James Tomlins

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