Pierre Ceyrac and Mark Miller explain the benefits of a global approach when investing in high yield.
Read this article to understand:
- The advantages of global versus regional approaches
- How a global process can exploit multi-currency arbitrage opportunities
- Why a global approach can help build more diversified and resilient portfolios
From Monet to Vermeer, many famous artists were renowned for their use of a limited colour palette, using just a few pigments in the creation of their masterpieces. Drawing on a narrow range of colours can improve a painting’s harmony while self-imposed constraint can foster artistic innovation.
Investment can be thought of as a blend of art and science, creativity and rigour. But most of all, perhaps, investment is the study of probabilities and an attempt to maximise the chance of success in the face of uncertainty.
As high-yield investors, we can improve the probability of investment success by taking a global approach to the asset class and exploiting the opportunities that come from a broader opportunity set. In this article, we examine the reasons why it pays to use a global palette when managing high-yield portfolios.
Fishing in a bigger pool
A global approach inevitably provides more alpha opportunities. The $1.3 trillion US high-yield market is comfortably the largest, three times bigger than its $425 billion European counterpart. But it has outperformed both the European and smaller sterling high-yield market only four times over the past 15 years on a dollar-hedged basis (see Figure 1).1
Investors that only fish in the US high-yield pool are restricting themselves to a universe of historically lower returns. Expanding the pool to include European and UK issuers improves your odds of being successful.
Figure 1: High-yield returns since the Global Financial Crisis by index (per cent)
Past performance is not a reliable guide to future performance
Note: Index shown is the Bloomberg Global High Yield xCMBS xEMG 2% Capped Index (USD Hedged).
Source: Aviva Investors, Bloomberg. Data as of December 31, 2022
Taking global exposure introduces currency risk. However, this can be efficiently and cheaply eliminated through hedging. Our global high-yield strategy is fully hedged to US dollars – we do not take any currency risk.
Multi-currency arbitrage opportunities
Two approaches are common within global high-yield strategies. One favours regional sleeves — typically US and European, reflecting the dominance of these two markets — the other emphasises a global method.
Both approaches draw on local market knowledge, research and trade execution. But in a sleeved approach, the portfolio is often split along regional or currency lines, separately managed from either side of the Atlantic and knitted together through a top-down allocation process.
Sleeved approaches miss multi-currency arbitrage opportunities
Allocations between the two sleeves are usually dynamic, thus the decision to increase or decrease regional weightings can be a potential source of alpha. However, such approaches miss the arbitrage opportunities afforded by investing in bonds from multi-currency issuers.
As the name suggests, multi-currency issuance refers to companies issuing bonds in local and foreign currencies. These bonds can be Yankees, dollar-denominated bonds issued by European and UK companies in the US, or reverse Yankees, euro- or sterling-denominated bonds issued by US companies in European and UK markets.
Why would companies want to raise debt in a foreign currency? It may reflect specific funding needs, for example, a US company needing to raise euro-denominated debt to finance the building of a European factory. The decision may also be driven by macro factors. Currently, US companies may wish to take advantage of lower European interest rates. By issuing euro-denominated bonds, they can issue debt with lower coupons than they could in the US, where the federal funds rate is currently significantly higher than the European Central Bank’s main rate.
Bonds issued in a foreign currency typically offer a spread premium, as they are not as closely followed in the non-domestic market, with limited coverage by analysts. This leads to arbitrage opportunities for globally oriented investors to exploit capital structure inefficiencies between multi-currency tranches of the same issuer, picking up excess option-adjusted spread. This allows a manager to increase the portfolio’s yield on a currency-hedged basis without increasing credit risk.
As followers of a coordinated global approach, we manage our global high-yield strategy in a holistic fashion
As followers of a coordinated global approach, we manage our global high-yield strategy in a holistic fashion. Our investment team collectively runs the strategy as a single portfolio from our London, Paris and Chicago offices, balancing risks across the portfolio. When we have a positive view of a multi-currency issuer, instead of making a pro-rata split between the company’s dollar and euro-denominated bonds, thereby diluting the additional value from the trade — as occurs with managers using regional sleeves — we select the bond that offers the greatest value and allocate fully to it.
Figure 2 highlights a multi-currency issuer currently held in the portfolio: Coty, a US-listed beauty and cosmetics group with brands such as Max Factor.
Here we can see Coty’s euro-denominated issuance trades wider than its dollar-denominated debt, much like the broader global market. This reverse Yankee is within the scope of our investment process and attractive to the investment team.
Figure 2: Arbitrage opportunity with multi-currency issuers
Coty
Past performance is not a reliable guide to future performance
Note: The information provided is for illustrative purposes only and the information about specific securities should not be construed as a recommendation to buy or sell any securities.
Source: Aviva Investors, Barclays Live. Data as of March 31, 2023
Arbitrage of multi-currency issuers can be an important source of alpha. In 2022 we allocated to several reverse Yankees, as we have also done in 2023. This has enabled us to access positive US macro drivers at the same time as capturing additional spread, while avoiding currency risk through hedging.
Hedging back to the dollar during a period of dollar strength has also served as a tailwind for the portfolio
As an aside, hedging back to the dollars during a period of dollar strength has also served as a tailwind for the portfolio, adding 280 basis points of annualised outperformance in 2022.
We believe having a credit research team based in different geographies can help to unlock these arbitrage opportunities. Having a presence in different regions also promotes a better understanding of local issuers — which is why we have also built our investment team with portfolio managers in Chicago, Paris and London — and enables us to effectively address a market becoming more diverse in its profile.
Diversification benefits
The different structures of the US and European high-yield markets provide diversification opportunities. From a sector perspective, the US has greater exposure to energy, whereas Europe is characterised by a higher weighting in financials (Figure 3 and 4).
Figure 3: A more diverse opportunity set improves diversification
Note: US HY: Bloomberg U.S. High Yield 2% Capped Index; Global HY: Bloomberg Global High Yield xCMBS xEMG 2% Capped Index (USD Hedged); European HY: Bloomberg Pan-European High Yield 2% capped index.
*Yield after hedging to USD. Ratings shown use the Barclays methodology.
Source: Aviva Investors. Data as of March 31, 2023
Figure 4: Credit quality and sector weighting diversification
Note: Charts do not depict attributes of any Aviva Investors product or strategy. US HY: Bloomberg U.S. High Yield 2% Capped Index; Global HY: Bloomberg Global High Yield xCMBS xEMG 2% Capped Index (USD Hedged); European HY: Bloomberg Pan-European High Yield 2% capped index.
Source: Aviva Investors. Data as of March 31, 2023
These sector biases are reflected in the respective credit quality of the two markets. The European market is characterised by significantly higher credit quality, with a greater concentration in BB-rated debt. Down the credit scale, the US market has double the exposure to CCC-rated issuers than the European universe: 10.8 per cent versus 5.3 per cent. For context, CCC-rated issuers are 18 times more likely to default than BB-rated issuers (Figure 5).
Figure 5: Average default rates by credit rating (per cent)
Note: Market value-weighted default rate from 1994-2021. Ratings are created using Barclays’ methodology.
Source: Aviva Investors, Moody’s. Data as of December 31, 2021
Going global also allows investors to better absorb idiosyncratic and regional economic shocks. Since 2011, the US and European markets have contended with major events largely unique to their geography. For Europe, the 2009-2012 sovereign debt crisis and 2022 Russia-Ukraine war caused serious market dislocations. In the US, weakness in the energy sector led to turbulence in 2015.
Going global also allows investors to better absorb idiosyncratic and regional economic shocks
By monitoring the option-adjusted spread differential between the two regions alongside evolving macro risks, we can shift allocations to capture the best risk-adjusted opportunities.
From Vermeer’s “Girl with a Pearl Earring” to Monet’s “Wheatstacks (End of Summer)”, there are many examples of artists using a limited palette to brilliant effect. But in the more prosaic world of high-yield investing, a broader approach can bring its own rewards.
Key takeaways
- Investors who favour regional high-yield portfolios over a global approach are unnecessarily limiting their opportunity set.
- Genuinely global approaches rather than regional sleeves provide a means to exploit arbitrage situations created by multi-currency issuers.
- A global high-yield portfolio can provide greater diversification through sector exposure and credit quality and build resilience against regional macroeconomic shocks.
