and editor Brenton Garen discusses the U.S. High Yield Sector with Mark Carlson, Senior Investment Strategist at FlexShares Exchange Traded Funds.

Mark – today’s topic is the U.S. High Yield sector which like other investment sectors has recovered from the negative COVID-19 impact in the first quarter of 2020. Where does the sector stand today and what should investors focus on within the High Yield sector today?

  • The High yield sector, like others, has recovered from the depths of the COVID-19 down turn in the first quarter on the monetary and fiscal support from the Federal Reserve and US Federal Government
  • Actions taken by the Federal Reserve in late March, including programs that included the investment in select high yield securities provided the markets with a much needed alternate source of liquidity and helped stabilize investors’ concerns with the sector
  • Some of the key developments in 2020 within the sector include an uptick in defaults and the increase in fallen angels, issuers that have been downgraded to high yield status from investment grade.
  • The economic downturn from the COVID-19 crisis has material impacted the entire economy as business and government shutdowns led to record unemployment and reduction in demand for goods and services.
  • Many investment grade rated issuers who were already under financial stress due to balance sheet leverage or business challenges were pushed over the ratings edge with the reduction in revenues, earnings and cash flows from the downturn
  • The corporate IG credit sector has seen roughly $150 billion in debt outstanding be downgraded to high yield ratings, aka fallen angels
  • As a result, the ratings make-up of the high yield sector has migrated to a higher average overall ratings level as more double B rated issuers are added from the IG space – today nearly 55% of the high yield sector is rated double B.
  • This increase in double Bs is not a recent phenomenon but has been an on-going trend for an extended period. As recently as 2008, the double B rating category made up roughly 35% of the high yield sector compared to the recent uptick.  Investors need to be aware that the high yield sector continues to evolve with the financial markets and the economy and to seek opportunistic investment strategies
  • Regarding credit stress, there has been an uptick in defaults and debt restructurings in the first half of 2020 compared to the relative benign default environment of the last few years, however many of these events have been concentrated in sectors that have come under acute duress during the recent economic downturn
  • Some of the sectors include Energy, retail and consumer discretionary dining, travel and leisure
  • With states and cities issuing stay at home orders and closures of major business sectors, Consumer spending has been negatively impacted hurting traditional retail and discretionary spending on food and entertainment away from home
  • The energy sector suffered a double hit as demand destruction combined with an on-going price/market shares war between global oil producers resulted in plunging energy prices driving levered energy firms over the financial ledge
  • Defaults are likely to continue to increase as the economic impact of COVID-19 will take time to address, however to date, the HY sector has taken this outlook into account, repricing these more vulnerable sectors for their increased risk
  • Despite these challenges in 2020, The sector overall has nearly recovered in terms of YTD total return from the downturn in price performance that resulted from a widening of credit spreads, known as option adjusted spreads, or OAS
  • While OAS spreads on a benchmark index like the Bloomberg Barclays High Yield Index, are still roughly 170 bps wider year to date, the “higher yields” of the sector have rewarded investors through higher income generation, offsetting negative price actions
  • This is one of the strategic advantages of the high yield sector, higher yields can provide more timely compensation for the risk of price losses as compared to other fixed income sectors

You’ve mentioned the importance of Yield in the total return opportunities in High Yield, how do you and Northern Trust/FlexShares recommend investors pursue yield within the sector?

  • The importance of yield cannot be understated when it comes to identifying the components of total return in the high yield space. Research by Northern Trust Asset Management shows that, on average, the entire amount of long-term total return performance in high yield typically comes from the yield income component, with this insight, it benefits investors to empathize yield in their high yield allocation
  • When we talk about emphasizing yield, we’re not advocating for a pure yield grab strategy. Many debt securities trade at very high yields because they represent a very high risk of capital loss thru default
  • Working with Northern Trust Asset Management Quantitative Research group, FlexShares has developed a high yield investment strategy that uses VALUE and QUALITY investment factors to construct an underlying rules-based index that seeks to maximizes risk-adjusted yield while remaining duration neutral (and unduly taking interest rate risk) and well diversified (avoiding undue allocation risk) similar to the overall high yield sector
  • This quantitative strategy seeks to identify and allocate towards risk adjusted under-valued issues and de-emphasize over-valued securities and issuers that our proprietary credit quality scoring model identifies as among the weaker financial and business profiles within their respective sectors and peer groups
  • The FlexShares High-Yield Value-Scored Bond Index Fund (HYGV) uses this multifactor model index to create an ETF that seeks to deliver improved risk-adjusted yield and total returns to investors

How should investors position the High Yield sector in their portfolios given some of its unique investment characterisitics?

  • Should be an allocation in most all portfolios, even client portfolios with low risk profiles due to income generation capabilities over time
  • We advise looking at High yield as the lowest risk sector of the class of higher risk sectors such as US or global equities or emerging market debt. This is because high yield captures a significant amount of equity risk premium, having good correlations with equity returns, but with lower volatility.  Through high yield, you participate in the upside of risk assets, but gain some level of downside protection.  This is an attractive alternative in the current uncertain environment
  • With its value and quality factor approach, HYGV intelligently assesses credit and market risk to construct a high yield portfolio that seeks to maximize risk-adjusted yield to deliver high current income and therefore, improved total risk adjusted returns to your client’s portfolios