Exemplary record
Meet the high yield strategy that has never had a default in two decades – not even during the financial crisis.
November 2023
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Welcome to another edition of SOURCE, a publication that shines the spotlight on selected funds and their managers. This time, we look at the Royal London Short Duration Global High Yield Bond fund. Find out more in our profile and Q&A with Azhar Hussain, head of global credit at Royal London Asset Management, plus supporting analysis from Citywire.
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This is a marketing communication for professional investors only. Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.
When the widely tipped recession will finally hit is anyone’s guess, but in the meantime, high yield investors are sitting with a healthy amount of yield.
Healthy yield ahead
Investors sitting on the sidelines of the high yield market at this late stage in the credit cycle are missing out on yields not seen in normalised market conditions for almost a generation. With credit spreads at about the 4% mark, the US high yield market is yielding a very attractive 8+%. ‘If we exclude the period around the financial crisis when we saw credit spreads really skyrocket, this is the highest absolute level of yield we’ve seen since the early part of this century,’ says Azhar Hussain, head of global credit at Royal London Asset Management. ‘When will the recession, if it happens, arrive? Waiting for it, as a lot of people have been doing for about 12 months now, incurs a huge opportunity cost of not being invested. ‘What high yield gives you at this part of the cycle, is a very high income, which buffers returns from here.’ Despite the fact that interest rates have been rising and with them, the cost of capital for companies, which in some cases has trebled, there has been plentiful liquidity within the high yield asset class. Default risk is also on the rise, albeit from very low levels. In previous cycles, defaults rose far higher than expected – something that Hussain does not expect to see this time around. ‘I don’t think that’s going to happen this time; I think high yield will prove to be more resilient,’ he says. ‘In the meantime, the amount of yield in the market means that there’s a large cushion which mitigates against a lot of things going wrong. A lot of defaults would have to happen before you wouldn’t get a positive return.’
Source: cccc
Manager bio here
Meet the manager
Shoring up defences
Hussain is speaking from experience – and from the shelter of a strategy that has the ability to navigate through different market environments. He has managed the Short Duration strategy in the same way for two decades, and the last 10 years of that via the Royal London Short Duration Global High Yield Bond fund, during which time it has never suffered a default. A big part of that is the fund is run quite countercyclically: when the future looks less certain and the market weakens, the duration of the portfolio shortens and the holdings naturally tilt towards more defensive parts of the market in terms of sectors and credit ratings. In the current environment, the fund has edged further into higher-rated credit – more double-Bs, no triple-Cs. It has started to shorten in duration. It has also increased its bias towards larger companies, which tend to be more resilient and have more options in weaker economic environments. Given such an investment approach, he reckons high yield deserves an allocation to portfolios throughout cycles. ‘In tougher times and particularly in the late-cycle part, having a focus and differentiating between different types of high yield strategies is important. Shorter duration strategies can potentially insulate against rising default risks whilst giving that high level of income to offset the opportunity costs of not being invested. ‘The high yield market of the past was a lot weaker structurally than the current high yield market, yet even so, the risk-return profile stands up pretty well against most other asset classes.’
Another trend that Hussain has observed in recent years is the growing internationalisation of capital. ‘What we’ve seen clearly over the last 10 or 15 years is that markets have been stitched together in a way that we haven’t seen before,’ he says. ‘That means that a lot of the macro trends get moved across from region to region quite rapidly.’ It is something that the Royal London Asset Management credit team has a bird’s eye view of. Its investment managers’ backgrounds have involved investing in all three strands of US, Emerging Markets and European high yield and its global credit strategies aim to take the best attributes of all three jurisdictions but without legacy biases. That is important because their experience tells them that running dedicated funds in any of these jurisdictions results in being forced to hold positions they often would not choose to own. As for their favourite area at present, the US is not only the largest global economy but also the largest and most longstanding high yield market. It commands more than half of the fund’s assets. ‘It’s a very resilient, longstanding market,’ says Hussain. ‘In high yield, what you want is predictability. Predictability of behaviour of companies really helps.’ Some other markets are comparatively less predictable. Europe carries more jurisdictional risks and slightly more liquidity risks. Emerging markets, which the team does like from a fundamental perspective, are home to various jurisdictions – each with their own facets. ‘From a technical perspective, emerging markets are definitely much harder to be invested in,’ says the portfolio manager. ‘Using all three elements together with a more defensive skew towards the US at this point is quite valuable. The US economy is, we believe, the strongest and even if we expect a weakening and a recession, we don’t expect this to cause defaults to rise hugely in the US, making high yield a potentially very attractive area to be invested in right now.’
Investing in predictability
Investment profile
The way in which high yield has behaved in previous recessionary environments is leading to some investor caution, and understandably so. But should parts of the market emerge from today’s weakening economic environment in relatively good shape – as the team believes – investors will be forced to reassess their viewpoint. ‘I think as we get through this weaker economic environment, what we’ll see is that the high yield market has changed quite profoundly,’ says Hussain. ‘It’s become a lot more institutionalised. It’s become a lot more investable and there are a lot more differentiated strategies within it, which potentially allows for a positive return through much more challenging environments. ‘High yield has shown its worth over the last 24 months within fixed income. Parts of the high yield market are continuing to show their worth and we think will go on showing their worth going forwards.’
Showing its worth
Another trend that Hussain has observed in recent years is the growing internationalisation of capital. ‘What we’ve seen clearly over the last ten or 15 years is that markets have been stitched together in a way that we haven’t seen before,’ he says. ‘That means that a lot of the macro trends get moved across from region to region quite rapidly.’ It is something that the Royal London Asset Management credit team has a bird’s eye view of. Its investment managers’ backgrounds have involved investing in all three strands of US, Emerging Markets and European High Yield and its global credit strategies aim to take the best attributes of all three jurisdictions but without legacy biases. That is important because their experience tells them that running dedicated funds in any of these jurisdictions results in being forced to hold positions they often would not choose to own. As for their favourite area at present, the US is not only the largest global economy but also the largest and most longstanding high yield market. It commands more than half of the fund’s assets. ‘It’s a very resilient, longstanding market,’ says Hussain. ‘In High Yield, what you want is predictability. Predictability of behaviour of companies really helps.’ Some other markets are comparatively less predictable. Europe carries more jurisdictional risks and slightly more liquidity risks. Emerging Markets, which the team does like from a fundamental perspective, are home to various jurisdictions – each with their own facets. ‘From a technical perspective, Emerging Markets are definitely much harder to be invested in,’ says the portfolio manager. ‘Using all three elements together with a more defensive skew towards the US at this point is quite valuable. The US economy is, we believe, the strongest and even if we expect a weakening and a recession, we don’t expect this to cause defaults to rise hugely in the US, making High Yield a potentially very attractive area to be invested in right now.’
The way in which High Yield has behaved in previous recessionary environments is leading to some investor caution, and understandably so. But should parts of the market emerge from today’s weakening economic environment in relatively good shape – as the team believes – investors will be forced to reassess their viewpoint. ‘I think as we get through this weaker economic environment, what we’ll see is that the High Yield market has changed quite profoundly,’ says Hussain. ‘It’s become a lot more institutionalised. It’s become a lot more investable and there are a lot more differentiated strategies within it, which potentially allows for a positive return through much more challenging environments. ‘High Yield has shown its worth over the last 24 months within fixed income. Parts of the High Yield market are continuing to show their worth and we think will go on showing their worth going forwards.’
Head of global credit, Royal London Asset Management
Azhar Hussain
‘What high yield gives you at this part of the cycle, is a very high income, which buffers returns from here.’
‘Shorter duration strategies can potentially insulate against rising default risks, whilst giving that high level of income to offset the opportunity costs of not being invested.’
Frank Talbot
Global high yield
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Royal London Short-Duration Global High Yield since inception
The portfolio’s return profile is very different to that of the underlying high yield market, which, despite being one of the more resilient areas in fixed income, has still been highly volatile. The fund has outperformed the index - ICE BofA BB-B Global Non Financial High Yield - since inception. This is an addition to comfortably outperforming the returns generated by cash-US Federal Funds Rate. 2022 was an excellent year for the strategy, restricting losses to 2.7%, while the average fund gave up 11.3%. These returns place the fund in the 96th percentile within the category*.
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Sector overview
Source: RLAM performance data. Based on monthly total return in USD, gross of fees and gross of tax. Fund cumulative returns are USD implied returns using the longer track record of the GBP share class (Royal London Short Duration Global High Yield Bond Z GBP Inc). This share class was in issue since the fund launch in February 2013.
Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.
Head of investment research, Citywire
*Performance figures and percentiles in the text are from Morningstar as at 30 September 2023. Performance is based on total return in USD, net of fees and gross of taxes. Fund performance is generated using the Royal London Short Duration Global High Yield Bond Z USD H Acc share class.
The strong downside protection characteristics of the portfolio are highlighted by having a maximum drawdown of just 7.5% since its launch in 2013. This is less than half of the 16.4% maximum losses represented by the index. Equally, the standard deviation of the fund is also considerably lower than the index, with an annualised volatility of 3.9% versus 7.2%. Effectively, the portfolio has managed to match the returns of the high yield index, whilst nearly halving the volatility investors have been exposed to.
Risk metrics since inception (Feb-2013 - Sep-2023)
Source: RLAM performance data. Based on monthly total return in USD, gross of fees and gross of tax. Fund cumulative returns are USD implied returns using the longer track record of the GBP share class (Royal London Short Duration Global High Yield Bond Z GBP Inc). This shares class was in issue since the fund launch in February 2013.
Royal London Short-Duration Global High Yield Bond rankings in Morningstar’s GBP Flexible Category
The fund has enjoyed a strong run and is in the second decile over the past three years. In addition, it is in the top half of the peer group over one month, three months and year-to-date. Only failing to outperform the sector average over the past twelve months which given the sharply rallying market is hardly surprising. However, the margin of underperformance is negligible.
Source: Morningstar as at 30 September 2023. Performance is based on total return in USD, calculated net of fees, gross of taxes, bid to bid, ignoring the effect of initial charges and with income reinvested at the ex-dividend date. Fund performance is generated using the Royal London Short Duration Global High Yield Bond Fund Z USD H Acc share class in the Global High Yield Bond sector compared against the oldest share class of each fund. Data for periods greater than a year are annualised.
In the strategy’s 20-year history, it has never suffered a single default or severe credit loss. And the 12 team members behind it have no plans to blot their copybook anytime soon.
Clean sheet
What is the Unique Selling Point of your approach to high yield investing?
Our aim is to have zero defaults and it’s something we’ve achieved in this strategy for a long period of time. I’ve personally run the strategy for two decades – more than 10 of those years at Royal London – and we’ve never had a default. We’ve never had a serious credit loss either. The reason for that is that it’s a very simple approach to high yield investing. It’s a strategy that invests in bonds that are going to be redeemed by issuers within the next 24 months and by having that approach, the fund naturally gets liquidity from issuers redeeming their bonds and the fund tilts in quite a countercyclical fashion when the environment weakens. What that means is that the fund ends up giving very steady, consistent returns throughout different periods. Two of the fund’s key selling points are in its name – global and short duration.
By investing globally, we can get the largest toolkit and our very purpose in this strategy is to be selective. We don’t want to be forced into any single arena or jurisdiction; we want to be able to look across the world for the best opportunities. By focusing on short duration, we make life easier for ourselves, too; trying to forecast a company for the next two years is clearly a lot easier than making longer-term predictions. The combination of a simple investment approach and as broad a universe as possible is why the strategy is as successful as it has been in terms of returns.
Why are these important?
We consider ESG factors that impact our credit, so on a credit-by-credit basis we score ESG factors. In fact, we call it ‘ESGC’ because we like to consider climate separately. That affects the sizing of holdings and the overall positioning of our fund.
How important are ESG considerations and how do you integrate these?
Fund manager Q&A
From a team perspective, we split our analyst coverage by sector. Our analysts are really close to the factors that matter within those sectors. The team is currently 12 strong, which includes 11 analysts. We think by looking across a sector and cross-jurisdictionally, you get good relative value analysis and the best idea generation. The underlying volatility of the fund is broadly half that of the wider market.
How do you find the best opportunities across countries and sectors?
Primarily it’s credit selection. The strategy aims to give about two-thirds of the credit spread of the high yield market. That means we end up investing in slightly easier investments that don’t have the volatility or the default risk that the rest of the market faces. Being short duration in itself helps. The other element is the microcredit selection, which means we pick the companies that are operationally less volatile. We have a lot fewer energy, automotive and retail companies than other strategies and a lot more companies with contracted cashflows. Finally, from a technical perspective, understanding who else holds the bonds that we’re investing in helps us to understand the potential volatility as well.
What tools and strategies do you use to reduce risk and volatility?
One good example is EG Group, a large petrol station owner that has been hugely successful over the last 20 years in terms of its growth. The issuer had a very small amount of 2024 bonds and a large amount of 2025 bonds. We invested in its 2024 bonds back in 2021, which we were looking to be redeemed in two years. We saw the company was highly levered but quite resilient and most importantly, we thought the 2024 bonds were easily redeemable because of the options the company had. It had a lot of assets, it had cash on its balance sheet and good internal liquidity. We thought the 2025 bonds would be a bit more challenging. As it has happened, the company did a sale and lease back of some assets in the US and used the proceeds to redeem our bonds. The 2025 bonds, however, are still outstanding. The cost of capital has gone up overall and has actually trebled for this company. The 2025 bonds are going to be a lot trickier to refinance. It shows the virtue of credit selection even within an issuer in a relatively benign environment.
Can you give me an example of your credit selection?
This is where the strategy really stands out. It’s done very well. It’s had zero defaults in much, much tougher periods. In the past, the high yield market was littered with much more difficult markets and much smaller returns. If I look forward, this economic environment is nowhere near as bad as the credit crisis, so I don’t think the overall default rate in the high yield market is going to go any higher either. From a strategy perspective, we’ve learnt a lot of good lessons about the companies that survive in these environments. Our record of zero defaults over 20 years is one we are very proud of and it’s a record we plan to sustain going forward.
Finally, what is the risk of default relative to history and how good is the outlook overall for high yield?
‘We have a lot less energy, automotive and retail companies than other strategies and a lot more companies with contracted cashflows.’
‘Our aim is to have zero defaults and it’s something we’ve achieved in this strategy for a long period of time.’
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