This is a complex moment for the global economy. After a relatively benign period, the policies of the US administration threaten to destabilise its fragile equilibrium. The uncertainty surrounding the implementation of tariffs and the resolution of geopolitical tensions continues to create a difficult backdrop for financial markets.
The impact of tariffs is unpredictable and there are likely to be implications for both sides. Tariffs are not a zero-sum game. Certain sectors are particularly vulnerable, such as auto makers, which have long and complex supply chains. Some of the tariff impact has been priced through currencies but the overall impact is erratic and hard to forecast.
We always adopt an opportunistic, stock picking approach to the high-yield market but we believe this approach is particularly apt for this environment. Individual sector selection has been very important over the past 12 months and we believe dispersion is only likely to increase. This means we will see more effective pricing of credit risk and greater differentiation than there is today. We are positioned to exploit this trend in 2025, rather than taking any significant macroeconomic views within the portfolio.
In aggregate, valuations in the high-yield sector are very rich but this belies significant differences beneath. For example, credit spreads in the US are among the lowest we’ve seen in recent history. The market is priced solely for an optimistic outcome for the US economy. Given the unpredictability of the new US administration, we believe a range of outcomes is plausible, and investors need to tread very carefully. In contrast, the European market is pricing in at least some potential for slowing growth. With that in mind, we are finding far more opportunities in Europe over the US.
Over the past 12 months we have benefited from exposure to sectors such as real estate and financials. The areas we are currently most active are those where there has been a lot of dispersion. This is a simple concept, reflecting the gap between the widest spread name in a sector over the tightest spread name in the sector, but it is illuminating on the market’s view of the forward credit quality of individual businesses.
At the moment, the greatest dispersion is in areas such as media, telcos, real estate and energy, and this is where we are focusing our attention. We have sought to commit the most capital to sectors that are trading at cycle-wide valuations. Today, some of the most cyclical sectors – leisure, automotive and consumer focussed sectors – are actually trading at cycle-tight valuations. We’re avoiding those areas, yet we see low tracking error funds extremely exposed to some of these cyclical sectors.
Although valuations are high, fundamentals in high-yield are stronger than they have been for some time. Much of the higher risk and more complex lending has moved into leveraged loans and private credit, which have seen significant growth as borrowers have raised capital outside the high-yield market.
While this has improved the fundamentals of high-yield, there are cracks starting to appear in leveraged loans and private credit. This is creating opportunities, with bond holders able to refinance the debt at substantial discounts and then improve the terms of the lending. However, it requires strong structuring expertise and is not an option open to everyone.
It is possible that there will be a fall-out from some of the more problematic lending. There is a maturity wall ahead and the longer rates are at these levels, the more problematic those refinancing issues are going to become. However, ultimately it leads to asset class volatility. That will drive dispersion and create attractive options for opportunistic investors.
Today, there are some opportunities emerging from cross-border deals. We are seeing activity in the financial sector, across both banks and other financials. For example, we have seen bank-owned fund managers buying insurance-owned asset managers, a consolidation trend that can continue. In the right environment, this can generate strong bond returns. However, these opportunities are relatively selective.
For the most part, it is single name ideas that are driving returns. The spread duration of the fund – the extent to which its price changes for a given change in its credit spread – is much lower than the overall market as we want to create a stable risk-adjusted yield without taking on too much market risk.
We cannot say with any certainty how the next 12-24 months are likely to evolve in financial markets. However, with valuations where they are, coupled with the prevailing uncertainty, we believe dispersion is going to pick up, and we want to be actively exposed to the mispricings that shift will create.