Repricing has made high yield attractive again – but risks lurk for passive investors

Recent repricing in the high yield bond market presents an attractive entry point for investors seeking higher income streams but rising liquidity risks and index concentration mean buyers should beware gaining passive exposure to the asset class, according to Aegon Asset Management.

Mark Benbow, high yield portfolio manager at Aegon AM, says recent price movements have led to yields rising to levels not seen since early in the Covid-19 pandemic, providing an opportune moment to buy into a market that offers solid company fundamentals and low defaults. However, he warns that gaining exposure to the asset class through tracker funds is increasingly fraught with risk.

“Heading into 2022, the high yield bond market was a tale of two halves,” he says. “On one hand, solid company
fundamentals, balanced technicals and the ongoing economic recovery painted a supportive backdrop. On the other, valuations were historically rich, with tight spreads and low all-in yields.

“Now, with the recent repricing, valuations are starting to look more interesting, with yields around 6.75%. But investors need to be selective. If they simply buy a passive investment, they will be gaining exposure to a bond benchmark that gives the most weight to the most indebted issuers. For obvious reasons, this is an illogical way to construct a portfolio.”

In the current environment, Benbow warns that passive investors are exposing themselves not only to highly leveraged businesses, but also the liquidity risks that are unavoidable with funds that must track a benchmark.

“Liquidity is the main risk for investors in passive funds right now, particularly ETFs,” he says. “When an ETF has unitholders redeeming positions, it has no choice but to sell at the market clearing price which leads to value destruction.

“The key problem is that passive structures lack emotional intelligence. They must buy or sell even if the liquidity isn’t there. This causes passive funds to achieve worse prices than active funds.”

Benbow is concerned that investors may also underappreciate the level of sector concentration in high yield bond benchmarks, something that – notwithstanding the risk inherent in being overexposed to specific sectors – has significant ramifications for those seeking to invest through an ESG lens.

“Energy is the largest sector within the global high yield bond market (14%) while the next largest is Basic Materials (8%), which is another commodity-exposed sector,” he says. “That means passive investors are exposed to underlying commodity risks more than they might appreciate or perhaps want. Indeed, some of the most environmentally damaging businesses within high yield are in the commodity exposed sectors.”

Not only do passive funds have no ability to pivot away from these businesses, as they are forced to retain large positions, they also may encounter long-term performance problems as they are increasingly starved of capital by climate-focused investors.

“If the marginal buyer base for these sectors is shrinking, the cost of capital will rise and the sectors will underperform,” Benbow says. “Passive bond investors will be left holding large exposures, while active managers – and their investors – will be able to simply avoid them.”

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