Global high yield floating rate notes delivered strong returns in 2023 during a period of heightened macroeconomic uncertainty that included double digit inflation and interest rate hikes. With 2024 well underway, inflation is returning to target levels and the prospect of slower, yet positive, economic growth has encouraged a cautious sense of optimism that a soft landing may be achieved. Here, we explore the potential prospects for this growing subset of the high yield fixed income universe as we approach the next phase of the interest rate cycle.
Many unknowns may lie on the horizon in 2024, especially at a geopolitical level considering ongoing conflicts and escalating tensions, and the fact that vast swathes of the global population are heading to the polls. But the macroeconomic backdrop paints a slightly different picture for now, in our view.
“In these uncertain times, caution is crucial and maintaining a focus on defensive and less cyclical parts of the market may play a fundamental role in riding out possible turbulence on the horizon.”
Following a year largely characterised by increasing fears of a recession and markets trying to call the end of monetary policy tightening, inflation is now falling and it appears that interest rates are at – or at least very close to – their peaks. A sense of cautious optimism prevails for the time being: a soft landing may just be achieved after the longest rate hiking cycle in recent history. Nevertheless, ongoing rate volatility remains a possibility looking ahead, meaning strategic allocation will continue to play a crucial role for investors as they navigate any potential challenges in the coming quarters.
Against a challenging backdrop
In spite of 2023’s challenging macroeconomic backdrop which saw the continued sell off of sovereign bond yields, high yield floating rate notes delivered particularly strong returns throughout the year, supported by their floating rate coupons and building on the momentum seen in 2022 when their effective lack of duration risk shielded the asset class from the worst of the bond market sell-off.
“Last year was a phenomenal year for floating rate asset classes,” notes James Tomlins, Fund Manager, Public Fixed Income – Europe, at M&G Investments. “As volatility was mainly driven by capital markets, investors effectively implementing zero durations could largely eliminate any turbulence coming from movements in the five or ten year part of the Treasury curve.”
He adds: “This provided a relatively smooth ride for HY FRN investors in 2023, all things considered, but the stars were very much aligned. Now the big question is: can that be repeated?”
The next stage of the cycle
As we enter the next stage of the economic cycle, fixed income investors across the board will be watching the movements of central banks closely as the effects of interest rate hikes continue to play out.
The case for investing in high yield floating rate notes in an environment of rising interest rates may be obvious, yet we believe the asset class still warrants consideration as the macroeconomic paradigm shifts once again. Indeed, although it currently appears we are reaching the end of the rate hiking cycle, the current environment remains conducive for high yield floating rate notes, in our view.
“It is worth noting that the market has been pretty bad at predicting future rate cuts over the last few years and has massively overanticipated them. In fact, the story up until last October was a repricing back to that higher-for-longer narrative,” explains Tomlins.
“Although I fully expect there to be some cuts this year, the pace could be delayed due to inflationary issues. What’s happening in the Middle East, for example, can have a pretty big inflationary impact due to increased pressure on supply chains and this can lead to capital losses.”
He continues: “As inflation appears to be a bit more sticky than markets anticipated, we see a big carry advantage to the environment where floating rate notes have tended to thrive compared to longer-dated instruments.”
The continuing inversion of sovereign yield curves combined with attractive relative spread levels, and relatively low expected default rates mean that HY FRNs are well positioned to potentially deliver solid returns in 2024 if the current macroeconomic environment persists, in our view.
Amidst the prospect of a soft landing, high yield corporate issuer fundamentals have held up reasonably well to date, although there may be an uptick in default rates as economies slow. In the event of a mild default cycle, we believe the corporate sector shouldn’t be too damaged. If default rates increase more aggressively, however, the senior-secured status within a company’s capital structure that typically categorises HY FRNs may help achieve higher recovery values and mitigate capital downside.
A defensive approach
In these uncertain times, caution is crucial and maintaining a focus on defensive and less cyclical parts of the market – such as food producers and distributors, and software or online businesses – may play a fundamental role in riding out possible turbulence on the horizon. Conserving a lower spread duration versus traditional high yield could also help mitigate capital loss from any spread widening that might occur as the year progresses.
Certain areas warrant a particular level of heed, such as zero interest-rate business models (including unsecured debt in the commercial real estate sector), while HY-rated banks also face greater fundamental challenges than their investment grade rated peers.
Investing in high yield floating rate notes requires particular focus in managing credit risk, especially as companies are affected by interest rates, inflation and may not be able to pay interest or return on capital. This is why fundamental credit research within an active investment approach will prove critical to capital preservation as we move into the next phase of the economic cycle.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.