High yield enters unchartered waters
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High yield enters unchartered waters

  • Higher inflation and interest rates are unknowns for the high yield bond market, but with inflation far above US and European 2% targets central banks are having to raise rates

  • Rising rates will put pressure on weaker companies, and could be particularly challenging for the private equity portfolio companies that make up a proportion of the HY universe

  • This is an environment in which we believe credit selection based on research intensity will become increasingly important

When the high yield bond markets were born 35 years ago, a period of sustained low inflation was just beginning. For the past two decades, inflation has remained subdued and interest rates far below the levels that prevailed for much of the second half of the 20th Century. This was a time of plain sailing for high yield.

Indeed, high yield’s birth followed the period of exceptionally high inflation from the 1970s and early 1980s. In the US, the high yield market began in the mid-1980s, partly helping to fund the leveraged buyouts designed to take advantage of companies’ under-used assets. Europe followed around a decade later.

So, with higher inflation and interest rates returning, it is fair to say that high yield bond markets are entering uncharted waters (Figure 1); an environment in which we believe credit selection based on research intensity will become increasingly important.

The 15 or so years so since the global financial crisis (GFC) have been characterised by quantitative easing and exceptional monetary conditions specifically designed to support companies. Interest rates have been at historically low levels – especially in contrast to the inflationary era of the 1970s and 80s. While the US Federal Reserve attempted to end the era of easy money in 2013 and then 2019, adverse reactions in financial market deterred it.

Figure 1: an inflationary environment … for the first time

Source: ICE BoA Indices/OECD, as at 30 September 2022

But in 2022 central banks have had no choice but to raise interest rates as inflation has breached 10% in the eurozone1 and 8% in the US2 – far above their 2% targets. As government bond interest rates also rise across the yield curve, and corporate spreads widen, the inevitable result is that companies’ funding costs are increasing to higher levels than we have seen for many years.

Rising rates put pressure on weaker companies

For leveraged high-yield issuers, the greater cost of servicing debt inevitably eats into cashflow and earnings. Some will simply earn lower profits and shrink their dividend payments; others may struggle to survive. We expect to see more pressure on the weakest credits – rated CCC – and there is a sense of a higher risk of default than in the past 15 years of cheap funding conditions.

To add to the pressure on corporate borrowers, today’s high inflation may last for some time. This is because many of the drivers of inflation are outside central banks’ control. Raising rates does little to solve issues such as logistics bottlenecks, commodity shortages and the scarcity of labour in some countries.

From a fund management perspective, understanding which companies can thrive in this harsher world is critical. Some companies are in a strong position: they make exceptional products and can control their prices. However, such robust firms tend to be more common among investment grade bond issuers.

The current environment could, however, be particularly challenging for the private equity portfolio companies that make up a proportion of the high yield universe. Rises in so-called risk-free rates – effectively, the interest rate on government bonds – increase the discount rate used to value equities in public markets. Hence, equity valuations such as price/earnings (P/E) ratios are falling. For example, the P/E on the US S&P 500 index is now 20 times (based on reported 2021 earnings), down from 25 a year ago, while that on the tech-heavy US Nasdaq index has fallen from 31 a year ago to 25, bottoming out at 20 in May3.

Surprisingly, there has been little distinction between the performance of bonds with different credit ratings in 2022. We do not believe this will last, however, because the weaker companies will struggle as interest rates rise and should subsequently trade at a higher risk premium.

Another challenge for high yield companies is the ongoing energy crisis and the energy transition. Together, they are making energy more expensive, putting further pressure on companies in all sectors (Figure 2). In such an environment we continue to favour traditionally stable sectors, such as telecoms, or companies with robust order books and stronger credit ratings in sectors such as automotives.

Figure 2: no sector left untouched

Source: ICE BoA Indices, as at 30 September 2022

Research intensity will count

So far in 2022, the cautious positioning in our portfolios has not been rewarded, which is frustrating. In such unprecedented times for high yield, though, intensive credit analysis is critical. We have a team and an investment process that has weathered a number of challenging credit cycles. They continue to seek out the higher quality companies that can survive this tough environment, with managements that have the flexibility to adapt their mindsets accordingly.

While today’s high and rising interest rates are unprecedented for high yield bonds, all crises are unique in their own way: for instance, the turmoil in financial markets triggered by the recent Covid-19 pandemic was unique, as was the 2008-2009 GFC.

It’s a question of deploying intensive research to find the companies that will ride out the storm. At some point inflation and interest rates fall; then waters will calm – for those who reach the other side.

24 November 2022
Roman Gaiser
Roman Gaiser
Head of High Yield, EMEA
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High yield enters unchartered waters

1 https://tradingeconomics.com/euro-area/inflation-cpi 30 September 2022
2 https://tradingeconomics.com/united-states/inflation-cpi 30 September 2022
3 Bloomberg, September 2022

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For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). This is a marketing communication. The mention of stocks is not a recommendation to deal.
This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.
In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) and relies on Class Order 03/1102 in respect of the financial services it provides to wholesale clients in Australia. This document should only be distributed in Australia to “wholesale clients” as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.
In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.
In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.
In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association and Type II Financial Instruments Firms Association.
In the UK: Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.
In the EEA: Issued by Threadneedle Management Luxembourg S.A. Registered with the Registre de Commerce et des Societes (Luxembourg), Registered No. B 110242, 44, rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.
In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland
In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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Important Information

For use by professional clients and/or equivalent investor types in your jurisdiction (not to be used with or passed on to retail clients). This is a marketing communication. The mention of stocks is not a recommendation to deal.
This document is intended for informational purposes only and should not be considered representative of any particular investment. This should not be considered an offer or solicitation to buy or sell any securities or other financial instruments, or to provide investment advice or services. Investing involves risk including the risk of loss of principal. Your capital is at risk. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole. The value of investments is not guaranteed, and therefore an investor may not get back the amount invested. International investing involves certain risks and volatility due to potential political, economic or currency fluctuations and different financial and accounting standards. The securities included herein are for illustrative purposes only, subject to change and should not be construed as a recommendation to buy or sell. Securities discussed may or may not prove profitable. The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Threadneedle Investments (Columbia Threadneedle) associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Information and opinions provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. This document and its contents have not been reviewed by any regulatory authority.
In Australia: Issued by Threadneedle Investments Singapore (Pte.) Limited [“TIS”], ARBN 600 027 414. TIS is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth) and relies on Class Order 03/1102 in respect of the financial services it provides to wholesale clients in Australia. This document should only be distributed in Australia to “wholesale clients” as defined in Section 761G of the Corporations Act. TIS is regulated in Singapore (Registration number: 201101559W) by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289), which differ from Australian laws.
In Singapore: Issued by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore 239519, which is regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). Registration number: 201101559W. This advertisement has not been reviewed by the Monetary Authority of Singapore.
In Hong Kong: Issued by Threadneedle Portfolio Services Hong Kong Limited 天利投資管理香港有限公司. Unit 3004, Two Exchange Square, 8 Connaught Place, Hong Kong, which is licensed by the Securities and Futures Commission (“SFC”) to conduct Type 1 regulated activities (CE:AQA779). Registered in Hong Kong under the Companies Ordinance (Chapter 622), No. 1173058.
In Japan: Issued by Columbia Threadneedle Investments Japan Co., Ltd. Financial Instruments Business Operator, The Director-General of Kanto Local Finance Bureau (FIBO) No.3281, and a member of Japan Investment Advisers Association and Type II Financial Instruments Firms Association.
In the UK: Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.
In the EEA: Issued by Threadneedle Management Luxembourg S.A. Registered with the Registre de Commerce et des Societes (Luxembourg), Registered No. B 110242, 44, rue de la Vallée, L-2661 Luxembourg, Grand Duchy of Luxembourg.
In Switzerland: Issued by Threadneedle Portfolio Services AG, Registered address: Claridenstrasse 41, 8002 Zurich, Switzerland
In the Middle East: This document is distributed by Columbia Threadneedle Investments (ME) Limited, which is regulated by the Dubai Financial Services Authority (DFSA). For Distributors: This document is intended to provide distributors’ with information about Group products and services and is not for further distribution. For Institutional Clients: The information in this document is not intended as financial advice and is only intended for persons with appropriate investment knowledge and who meet the regulatory criteria to be classified as a Professional Client or Market Counterparties and no other Person should act upon it.

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