By Jonathan Butler, Head of European Leveraged Finance and Co-Head of Global High Yield, PGIM Fixed Income
Rapidly changing global markets have become a key feature of the current environment. While deciphering the implications of differences in GDP growth and relative value can be disorientating, it now works in favour of an active, high yield global strategy.
However, these factors are only part of the reason to invest in different regions. Another feature of an active global high yield strategy is its flexibility to take advantage of structural nuances in credit diversification, issuer spread premiums and opportunities.
Mixed economic outlook
Global fixed income strategies now offer significantly higher yields than a year ago. Investors need to consider the sectors that may be appropriately suited to their objectives. For those focused on total return, our macro scenarios continue to favour the benefits of a high-yield global allocation.
While a range of risks lie ahead, there are also recent developments worth considering. For example:
- runaway inflation has been mitigated by falling goods prices,
- slowing growth in China has been mitigated by the abandonment of zero COVID measures,
- the ongoing energy crisis in Europe has been limited (for now) by mild winter weather, and
- the general tightening of monetary policy has so far been met with resilient economic activity.
In the US, we see equal probability of a recession and a soft landing, with a potential bias towards the latter as labour demand remains historically high.
Also read: Surprise RBA Rate Hike and Hawkish Tones
The soft-landing scenario (i.e. with inflation falling towards the Federal Reserve’s 2% target) could support the asset class – which accounts for around 75% of the global high yield universe – as long-term interest rates and credit spreads could remain high enough to offer attractive income levels. Even in the event of a recession, when spreads could widen over a short period of time, rates would likely rally and reinforce the prospects of a positive total return.
Europe faces higher “imported inflation” due to the effects of higher energy costs on goods prices, which is more difficult for the ECB to control. As a result, our baseline scenario is one of stagflation, as policy rate hikes dampen demand and inflation remains high.
While investors tend to focus on the upward and downward movement of interest rates and spreads, the current macroeconomic configuration also lends itself to the possibility of a rollercoaster ride. In a scenario where rates and spreads generally move sideways, high yields and income-related returns in the high yield universe would be another factor supporting the sector’s performance.
European high yield: the benefits
When viewing the sector from a total-return perspective, the prior increases in interest rates and credit spreads will remain important aspects going forward. In the event of stagflation, spreads and rates have already been repriced to some extent, which should help cushion the shock, while a recession could coincide with a fall in rates, which would offset some of the volatility in credit spreads. If rates and spreads move sideways, the sector should generate attractive levels of income, while if rates remain near their highs and credit spreads contract, the sector’s total return potential could be enhanced.
Although the European high yield asset class represents a distinct region of the markets, its strengths meet the diverse needs of investors around the world. It remains an asset class to keep in mind as conditions across global markets change rapidly.
