High yield: The long and the short of it

October 23, 2024

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With good carry but tight spreads, this could be the time for a hedged approach to high yield, argue Jamie Cane and Greg Temo.

High-yield markets have had a strong run for much of the past two years. European and US markets gained 12.36% and 13.40% in 2023 and are up 7.90%¹ and 6.35%² so far this year, as inflation fears have subsided and hopes of a soft landing have grown.  

While carry remains supportive of an allocation, Jamie Cane (JC) and Greg Temo (GT), who manage our European and US long/short strategies, explain why now could be a good time for investors to consider high yield via a long/short approach, which seeks to capture upside with enhanced downside protection.

Past performance is not a reliable indicator of current or future results.

Why might investors consider a long/short approach to US and European high yield rather than a conventional long-only strategy?

JC: Yields and carry remain somewhat elevated. The fundamental picture is broadly fine and the technical is exceptionally strong, after sizeable inflows into the high-yield market. However, tight credit spreads merit caution. Carry still offers a decent total return opportunity at these levels with supportive central banks and the strong technical, but the propensity for additional returns from spread tightening has been reduced mechanically by the rally that has taken place. 

In this context, a hedged approach to investing in high yield makes sense, in our view – allowing investors to gain exposure to carry, but with more downside protection than a long-only strategy. Due to the combination of high carry but tight spreads and relatively low implied volatility, it has rarely – if ever – been cheaper to hedge long exposure using options.

How do you look to capture upside but mitigate the downside?

GT: The US long/short strategy has captured 62% of the upside but only 23% of the downside. This has enabled it to outperform the US high-yield market despite having a fraction of the volatility, beta and drawdowns. The European strategy, with a higher-beta profile, has captured over 100% of the upside and mitigated 30% of the downside, achieving over double the return of the European high-yield market since inception.

There are two main factors behind this asymmetric upside/downside return profile. The first involves the use of options, in a very simple and insurance-like way, to hedge the Core Long part of the portfolios. We pay a small premium upfront but receive a much larger payout if spread widening occurs, much like an insurance contract. The small premium does not detract greatly from the upside capture but the larger payout on a spread widening has been effective in protecting portfolios during selloffs.  

Secondly, we have a simple approach to portfolio beta. When spreads are tight, we focus on downside mitigation - adding hedges and reducing beta. Conversely, when spreads are wide, we take profit on hedges, increase beta and focus on upside capture.

In what kind of environments do long/short strategies tend to outperform the broader market? Are we in such an environment now?

JC: Our long/short strategies are designed to work through the credit cycle and have been tested in a variety of market conditions – from rallies in 2019 and 2023 to large selloffs in (March) 2020 and 2022. What differentiates us is that we provide downside protection when spreads are tight. This enables us to invest more aggressively when more attractive valuations emerge.

The European strategy’s average beta is between 0.7-0.8 and we tend to run it within a range of 0.5-1.0. The US strategy has an average beta of just under 0.3. Neither are market neutral. The goal is upside capture with downside mitigation, and this has been reflected by significant outperformance over the high yield market through the cycle.

GT: The US strategy historically has run different betas. In 2022, the whole market sold off. It was one directional. Yet we were able to mitigate over 70% of the downside. This year, we have been able to capture around 80% of the upside. Even though the strategy’s beta has averaged about 0.3, we can tactically move it around, from market neutral based on hedges to a mid-month beta as high as 65. But, like the European strategy, the focus is on downside protection.

It’s difficult for us to capture daily volatility and one-day reversals, but when there are longer bouts of volatility, this is where these strategies can accelerate as we move the hedges around, as well as the underlying cash holdings.

Conversely, what market conditions are most difficult to outperform?

GT: We will almost always have some degree of hedging in place, which can be a headwind during strong rallies. But we invest more aggressively with fewer hedges and a higher beta when spreads are wide and attractive so have a good track record of catching more upside than downside.

Right now, the high yield market is callable. As prices and valuations rise, it limits the remaining upside. The broader market is trending back to its lows in terms of negative convexity, so the upside/downside is not as favourable, especially if you include the potential risks (geopolitical, elections etc). The investment case is now much more carry focused. It is a lot cheaper to hedge and, because spreads are tight, one is giving up less upside by doing so.

Past performance is not a reliable indicator of current or future results.

Can you talk us through the component parts of your strategies and the potential benefits?

JC: Both are set up in broadly similar ways. The European strategy is comprised of three books: Core Long, Overlay and Arbitrage (Figure 3).

Figure 3: The components of our European long/short strategy

The Core Long book is where we seek to capture the upside/carry, predominantly in cash bonds. But we have an extended toolkit and can invest in credit default swaps (CDS), tranches, collateralised loan obligations and leveraged loans. This offers a better way to capture relative value; if the CDS is trading wide to a bond, we can invest via the CDS. 

The Overlay book is for hedges and short positions we use for downside protection. Firstly, we have macro hedges, such as options or instruments like Crossover or CDX high yield. Then we have single-name shorts that fall into two categories: fundamental shorts are used when our analysts identify a company with significant downside potential as default risk is mispriced, and relative value shorts, where we do not necessarily dislike the company but believe its bonds are trading too tight. This allows us to reduce beta, creating more room to invest in what we believe are better-value bonds in the Core Long book.

Our Arbitrage book is where we look to generate market neutral returns by capitalizing on pricing dislocations, rather than taking a directional bet. A classic example would be a basis trade, where a bond’s spread is trading very differently – say 100 basis points (bps) wide – to its CDS contract, with no obvious reason. We buy the bond, buy the CDS protection and if nothing happens, we clip the 100bps differential. However, if the price corrects back to flat, we can capture a few points of upside.

 

References

1.ICE Data Platform, as of 30th September 2024. ICE BofA Euro BB/B Non-Financial Index (HP4N).
2.ICE Data Platform, as of 30th September 2024. ICE BofA US Cash Pay High Yield Index (J0A0).

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of October 2024 and may change without notice.

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Index Descriptions

HE00 - The ICE BofA Euro High Yield Index tracks the performance of EUR dominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million.  

J0A0 - The ICE BofA US Cash Pay High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt, currently in a coupon paying period that is publicly issued in the US domestic market.  Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

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