Podcast: Short-Duration Debt: High Yield Plays for Today's Markets

Danny Sarnowski: Hello. Welcome to SpringTalk. I'm Danny Sarnowski, senior portfolio specialist for the Plus Fixed Income team at Allspring Global Investments. Today, I'm joined by senior portfolio managers and high yield specialists Chris Lee and Mike Schueller. Gentlemen, thanks for joining me.

Mike Schueller: Thanks for having us, Danny.

Chris Lee: Thank you for having us, Danny.

Danny: I wanted to have this discussion today because so much has happened over the last several months. It can be difficult to remember, given we're filming this at the end of May, but if you rewind the tape to the immediate aftermath of the U.S. election in November, markets were really doing well. Risk was booming, and it just feels like we've all been through so much in the intervening months.

Mike: Indeed, there was widespread optimism that the incoming administration would pursue business-friendly policies as well as tax cuts, and the resulting euphoria left investors really bullishly positioned. Against that backdrop, the Liberation Day tariffs really caught investors offsides and that resulted in significant volatility.

Danny: We've seen a few sort of mini cycles actually since that November election, and we've seen prices boom and bust a few times. What drove that volatility?

Chris: In a word, Danny, uncertainty.

Mike: The initial surprise regarding the magnitude and the breadth of the tariffs; concerns about how our trading partners, especially China, might react; and then the sudden reversal of those tariffs later—and now, most recently, we've seen a court overturn many of those initial tariffs—it's just created a significant amount of volatility and uncertainty for investors to digest.
Chris: In high yield, as an example, spreads got as tight as the mid-200s as recently as late January. And then, by the time we got into early April, spreads had gotten into the mid-400s, albeit for a very, very short period of time—maybe just hours. And, seemingly, we've been at every point in between the mid-200s and mid-400s since.

Danny: I know we've seen a number of the soft data series really deteriorate over the last several months, even leading into Liberation Day. But has that started to bleed through into the hard data yet?

Chris: Well, not yet, Danny. And you're right. The soft data has deteriorated some. We've seen some deterioration in consumer confidence data. We've seen some deterioration in consumer credit data. Specifically, the percentage of consumer credit card borrowers who are making just the monthly payments has increased pretty remarkably. But it's still too early to determine whether any changes in trade policy are having an effect on the hard data or too early to tell how the changes in trade policy or fiscal policy will have an impact on GDP (gross domestic product) and growth.

Mike: And, actually, we have had a few initial hard data points such as inflation and unemployment, which have suggested some resilience to the economy. Now, it's true that we did see a pretty negative Q1 GDP print, but of course, that was largely distorted by the almost-record imports that we saw as businesses and consumers front-ran the expected tariffs.

Danny: Yeah. How have the high yield markets specifically reacted to what we've experiencing?

Mike: Well, as Chris mentioned, we initially saw pretty significant spread widening. We've largely retraced that. And at this point, markets have more or less priced out that left tail or worst-case scenario and appear to be discounting a pretty constructive economic outlook for the rest of the year, as well as a reasonable resolution to the trade war.

Danny: So, what would be your expectations for the high yield markets over the next several months?

Chris: Well, we do, Danny, expect growth to slow a bit. We came into the year expecting roughly 2% growth. This may be going down to 1.5%, give or take. And, at the moment, high yield default rates are in a very, very healthy place. The trailing 12-month default rate is right around 1%. But with growth slowing, we do expect the default rate to slowly creep higher in the upcoming quarters. But, overall, defaults are pretty well contained. They're well contained within the isolated troubled sectors and isolated troubled companies.

Danny: High yield companies in general tend to be a little less trade sensitive. Is that fair to say? I mean, relative maybe to the mega-cap multinationals that make up the S&P 500?

Chris: On average, high yield companies are smaller than the S&P 500. And they tend to be a little bit more domestically oriented. And particularly in certain sectors within high yield, they're much less trade dependent and sensitive to the changes in trade policy.

Danny: Well, from what I'm hearing, it seems like you believe that, overall, the market that we have and we're likely to have over the coming months is fairly supportive for high yield. Is that fair?

Chris: That is fair. We think a 1.5%-ish type of growth environment, moderate inflation that could be 2.5%, 3%, is generally a pretty constructive environment for the performing part of the high yield market. When you look at the upper end of the high yield market, balance sheets are in very good shape, earnings have generally held up pretty well, and we expect those companies to continue to maintain access to the capital markets to be able to refinance maturities.

Mike: We do have a constructive outlook for the high yield market. But as I mentioned earlier, the market has priced in a pretty positive outcome and yet we don't have resolution on the trade war. We have the uncertainty caused by the recent court ruling. We're not sure how the administration is going to react to that court ruling. And so, we do think that there is the potential for growth to slow in the second half as the uncertainty works through into that hard data. So, we expect some volatility, which makes us cautious, particularly about the lower-quality portion of the high yield market.

Danny: Got it. So, we're not done with uncertainty. It's likely to persist. And, typically, when we talk to investors, we'd say if uncertainty is rising, we would ideally like to position portfolios either where uncertainty is lower or where compensation for bearing that uncertainty is higher or both. So, what would you say to that?

Mike: We would agree with that. And we are in a unique environment where investors can shorten up their duration, improve the quality of the assets in which they invest, and not necessarily have to give up a lot of income. We have a yield environment that looks really attractive relative to what we've seen since the Global Financial Crisis. And, so, we think this is a good time for investors to focus on shorter-duration, higher-quality assets.

Danny: So, given that you're talking about the front end of the curve, what are your expectations, Chris, maybe for the Fed (Federal Reserve) in this environment?

Chris: We do think that the Fed is going to initially have to be on hold as they wait and see how any changes in trade policy have an impact on the real economy and have an impact on growth. And as we wait, that does keep the front end of the Treasury curve anchored at today's rates.

Danny: Great. So, the front end is relatively static or anchored. Maybe at some point they get to cut and you've got the opportunity for some price appreciation if you're on the curve and get the benefit of that. So, that seems attractive. Talk to us a little bit about where in the high yield credit stack you think is most attractive.

Mike: Well, as we mentioned, while we do have a fairly constructive outlook for the broad high yield market, there is significant uncertainty remaining. And we've seen a real significant rally in lower-quality assets within high yield since the early part of April. So, we do think it makes sense to focus on the higher-quality portion of the market. Historically speaking, the 1- to 3-year BB index has shallower drawdowns. So, when you look at 2018 or 2020 or even the most recent episode within April, you get a shallower drawdown than you do in the broader high yield market, even on the front end. And you typically get a quicker recovery. Investors have a line of sight to those bonds being refinanced. They tend to have confidence in those bonds. And that facilitates what we call the pull-to-par and a quick recovery in those assets. So, in an uncertain time when you're getting paid an attractive compensation, we think it's a good place to sort of hide out and wait to see what happens.

Danny: Great.

Chris: Danny, in a nutshell, the near-term maturity anchors value because of the increased certainty that investors will get paid back sooner rather than later.

Danny: Got it. Well, in periods of volatility in fixed income, income is your friend and we're always trying to find the optimal risk/reward ratio or mix to source that income. And it sounds like from the two of you, the front end of the curve and the higher-rated portion of the high yield stack is an attractive place to source income without taking much duration risk and without being exposed to that deepest, lowest-rated credit risk, especially at a time when volatility and uncertainty is likely to persist. Is that fair?

Chris: That's exactly right, Danny. And one of the things that investors may be tempted to do is say, well, I can remove some of the volatility by just staying shorter. So, you might compare 1- to 3-year BBs against an index like a 0- to 3-year high yield index. And while both of those particular parts of the market reduce duration and can give you the majority of the yield that the broad high yield market provides, you need to remove the CCCs in order to reduce that volatility. Because once you introduce the CCCs into the volatility during uncertain times, that can create potential blow-up effects within your portfolio and you don't remove the volatility that you want to remove.

Danny: Got it. Well, this has been very helpful. I really appreciate both of you joining me today and sharing this information with our audience.

Chris: Danny, thank you for having us.

Mike: Thank you.

Danny: And to our audience, thank you for joining us on SpringTalk.