Rising rates mean that core fixed income investments will face hurdles in the coming months, and as advisors seek ways to generate income, some are landing on high yield as an option. High yield investing can come with enhanced risks, and finding the balance between maximum yield and risk tolerance is something that active management can help to navigate, as discussed by Principal Global Investors in a recent webcast with ETF Trends’ CEO Tom Lydon.
Seema Shah, chief strategist at Principal Global Investors, opens by discussing how despite COVID-19 impacts, the market was very strong going into 2022, driven by strong consumer demand and monetary stimulus. The pandemic continues to impact global supply dynamics, however, with variant surges causing shutdowns and impacting supply and production.
The pandemic has caused inflationary pressures that geopolitical tensions have only exacerbated, and labor demand continues to outstrip labor supply, increasing wage pressures; in short, there is no shortage of inflationary pressures, including the price increases in commodities.
“The push-up in commodity prices is particularly damaging to this inflation story, it’s going to keep going up,” Shah explains. “With upward movement in commodity prices, re-intensification of the supply chain, this inflation picture is not getting better anytime soon.”
Principal anticipates the possibility of recession around the end of 2023, given the interest rate increase expectations by the Federal Reserve. When interest rates hit 2.5% and higher, it’s considered restrictive territory and affects risk assets; with the Fed expected to increase rates at every meeting for the rest of 2022 and talks of two 0.50% rate increases baked into those hikes, the interest rate could be at 2.4% by the end of the year.
Mark Cernicky, portfolio specialist for Principal Global Fixed Income, explains that high yield typically performs well in rising rate environments, and in a market of volatility, active management offers opportunity to capture high yield while mitigating risk. The pandemic has actually served to improve the credit quality of high-yield assets, with many zombie companies leaving the space and not returning.
“High yield does well in a rising rate environment for several reasons; the first is that it’s a shorter-duration asset class,” Cernicky says. “Also because it’s higher yield, it has that coupon cushion that can absorb higher spreads and higher Treasury rates.”
The Benefits of Active Management at Passive Fund Prices
Principal believes that high yield carries significant negative ratings migration risk, and passive funds that buy into the entire market end up with exposure to lower-quality debt and higher risks of being downgraded over the course of a year.
The Principal Active High Yield ETF (YLD) is an active, high-conviction, top alpha fund that uses fundamental research and seeks to generate yield and alpha from ratings inefficiencies. Cernicky believes that it’s a fund that will produce higher yields than strategies in emerging market debt, multi-sector fixed income, preferreds, and other high-yield ETFs and mutual funds on the market.
“If you’re looking for a strategy that does not use leverage in it, this is going to be one of the highest-yielding ones out there; it’s also attractively priced at 39 basis points,” Cernicky says.
YLD begins with a high-yield investment universe of around 1000 issuers and first eliminates bonds that aren’t investible before Principal completes its own internal research on the remaining 400 companies to identify what it considers good companies for tomorrow based on its own internal ratings system. Valuations are also taken into consideration to determine what companies are best for high yield, and the remaining companies are ranked based on total return.
Matthew Cohen, head of ETF sales team at Principal Global Investors, closes by discussing the benefits of YLD in its price point for an active fund, as well as its pure exposure to high yield. The fund has credit research at its core as it seeks to identify the top performers, is fully transparent, and the portfolio managers are able to de-risk the portfolio if needed.
As Cohen puts it, “A lot of investors today are asking me about drawdown protection; you’re seeing it live. Mark just talked about this being one of the worst quarters for high yield, and you’re seeing some of the protection that we can provide for investors.”
Financial advisors who are interested in learning more about the benefits of active management within high yield can watch the webcast here on demand.