High Yield Bonds & Loans: Adapting to Changing Markets

Greg Campion: High- yield bonds and senior secured loans have continued to garner significant investor interests in recent months. And maybe that's not all that surprising given the attractive income they offer and an economic backdrop that continues to surprise to the upside. But as market conditions continue to evolve and risks from geopolitics to inflation remain top of mind, investors are rightly asking, can high yield continue its strong run?

Brian Pacheco: Despite really strong returns in 2023, all in yields remain attractive. We think leveraged loans are particularly compelling right now, but whether you're talking about loans or bonds, US or Europe, it's important to remember that these are below investment grade asset classes and you really need big teams on the ground doing the bottom up credit selection that's required to be successful in these markets.

Greg Campion: That was Brian Pacheco, a portfolio manager within Barings' Global High Yield Group, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on the show, High Yield Bonds and Loans: Adapting to Changing Markets. Before we get into the conversation, if you're not already following us and you're interested in hearing our latest thoughts on asset classes like high yield, private credit, real estate, and more, just search Streaming Income on Apple Podcasts, Spotify, YouTube, or wherever you get your podcasts. With that, here's my conversation with Brian Pacheco. All right, Brian, welcome to the podcast.

Brian Pacheco: Thanks for having me.

Greg Campion: Excited to have you here. You are a first time guest on the podcast, so excited to dive in and talk about high yield bonds and loans with you today. And since it's your first time on the podcast, I was thinking maybe we would just start with a quick intro. I think you're a pretty well- known person around the firm here and I'm sure to many of our clients as well, but maybe some of our listeners and our viewers out there haven't been exposed to you yet. So tell me a little bit just about your role at the firm here at Barings, the team that you're on, and then maybe a little bit about what you were doing before this role.

Brian Pacheco: Sure. So my name's Brian Pacheco. I'm a global high yield portfolio manager. I'm part of a team of over 70 investment professionals, over half of which are analysts that do bottom up credit analysis. I focus on multi- asset credit, high yield leverage loans. Prior to my current role, I was the sector head for the US commodities team, and my focus and coverage responsibilities were in the energy sector.

Greg Campion: Awesome, thank you for that overview. Yeah, part of a very large team here, I think one of the largest high yield teams in the industry. It's always a pleasure to get to interact with you and the team here. And that energy background, I'm sure comes in handy when you are evaluating high yield opportunities. I don't think this conversation's going to devolve into a debate about the oil price, but-

Brian Pacheco: I hope not.

Greg Campion: ...at least I think I have the right person in front of me who's well qualified if it does. Well, let's get into the discussion about high yields more broadly. And maybe to set the stage for that, I want to talk a little macro first. So you were a part of our 2024 credit outlook panel that we hosted back in November. Just thinking back on that time, I recall you as being generally bullish on high yield bonds and loans.

Brian Pacheco: Thanks for remembering that.

Greg Campion: Yeah, that call has proven to be fairly prescient so far, but that was against a pretty different backdrop. It's only four or five months ago, but if you think back at what we were looking at then we were talking about, I think there was a lot of worries that the economy was about to slow down. There was obviously calls for quite a few rate cuts in 2024. Today things have seemingly changed a little bit. So maybe let's just start high level. Tell me about the overall landscape for high yield and maybe how that's changed.

Brian Pacheco: Sure, yeah. So when we recorded our panel in early November, I think the term that was being thrown around a lot was hard- ish landing. So the expectation was that we were going to have a slowdown and, or recession that was going to cause some credit problems, but that was going to open the door for Federal Reserve interest rate cuts and effectively the Fed put would be back in play and that would keep things from getting too bad. So following that recording, we had a couple very favorable CPI prints. The Fed had a very dovish pivot in December, which really put gasoline on the fire, and we had a massive rally going into year- end. I think high yield returned something like 8% and a lot of folks called it an everything rally because you had both treasuries rallying and risk assets rallying. So as the calendar year turned, we were priced for perfection. Someone would call that price for immaculate disinflation. And the expected Federal Reserve interest rate cuts by the market had increased to something like a 150 basis points. Fast- forward to today, the data has not been cooperative, meaning the economy has been almost too strong. Inflation has been sticky. We had a couple hot CPI prints and rates have essentially roundtrip to the market's now predicting about 40 basis points of interest rate cuts. And the narrative has gone from a soft- ish landing back to potentially no landing and we're back to higher for longer. So higher for longer benefits leveraged loans, which we really like, and it benefits short duration assets that are high quality and offering favorable yields.

Greg Campion: Let's talk about loans as an asset class. Rightly or wrongly, I think there is a perception out there that loans can be viewed as a play on interest rates. All right. So this is a very simplistic way to look at it, but if as a floating rate asset class rates go up, maybe it's time to buy loans, rates go down, maybe it's time to sell loans. So I guess what I'd like to ask you is two things. One, first is that two simplistic of a way to look at the asset class. And two, you mentioned that you and the team are constructive on loans. Let's get into that. Let's understand what that case is today.

Brian Pacheco: Sure. Well, I don't really think about loans as a play on rates, although your point is well taken that if rates are going up, you want to be in a short duration asset class and loans are as short as it gets at close to zero. I think of loans as an income generating asset class with low volatility. That income component is why over the last 25 years in the US at least, there's only been three negative total return years in loans. And in Europe, I think it's only been four negative total return years. That income component is now sitting at 9%, which is very high relative to the long- term average in the mid- fives. So the reason we're bullish on loans is you have that high contractual income, you have a strong economic backdrop. Corporate balance sheets are in good shape and it's really one of our favorite asset classes and we're max overweight in our multi- asset credit funds as a result.

Greg Campion: Yeah. So in a number of your multi- asset credit strategies, you all have the ability to move in between loans and bonds, US and Europe-

Brian Pacheco: Correct.

Greg Campion: ...some other asset classes like CLOs, and that's very interesting to hear that you're... Would it be very much toward the top end of where you've been historically in terms of the allocation of those strategies and loans?

Brian Pacheco: Oh absolutely.

Greg Campion: Yeah.

Brian Pacheco: We include CLOs in that because we like CLO liabilities for the same reasons we like loans. But yes, we're finding the upper bound of what we think is appropriate.

Greg Campion: Okay. Now you had alluded to the steady nature of the returns in loans. Talk to me a little bit about that, because I think that's a potentially underappreciated point, especially when you consider time periods, like the one you were referencing earlier the end of last year. Tell me a little bit more just about that idea of that return stream.

Brian Pacheco: So when you look at the return profile over last year, for example, loans made money maybe every month, if not every month, almost every single month. So it was a steady path to that 13% or so return. High yield on the other hand, which is an asset class we also like, but has longer duration earned about two thirds of the total return in really the last two months of the year because you had spread tightening and you had rates rally. You'd see it even more in IG and the more duration you have, the more you see that impact.

Greg Campion: That's right, yeah. I think IG and some of the emerging market debt asset classes were very heavily concentrated their returns into that last six weeks of the year. So that shows this point of just the juxtaposing loans versus bonds and what that return profile looks like.

Brian Pacheco: Yeah, sometimes in thinking about that 9%, if you just break it down monthly, it's even more obvious, it's 75 basis points every single month you're earning by owning loans. So to get too tactical on your entry point to us just doesn't make a lot of sense because the opportunity cost of that carry is significant.

Greg Campion: Yeah. Now where are we from an evaluation perspective? Because I know, and we will talk about bonds, and I know there's maybe some people who are concerned that we're nearing the high end of historical evaluation ranges on the bond side, where are we when it comes to loans?

Brian Pacheco: Yeah. So loans are almost bang on the 50th percentile if you're looking at spreads. There's a little nuance to the story. The higher end performing part of the market is a little bit tighter. The stressier end of the market tends to be wider. So if you look at that average, it's a little misleading. If you wanted to invest in high quality double B or high quality single B loans for example, your spreads aren't quite as wide, but it's pretty reasonable compensation relative to history. Particularly if you look at the credit quality of those single B and double B assets, we don't think there's a very high probability of default from that cohort. If there are defaults and given the strength of the economy, we very well may be past peak defaults, but it'll be in that lower end of the market that sub- 85, sub- 80 price portion of the market, which is only around 8% of the loan market. And the investors have been predicting a default cycle now going on for almost two years. So a lot is in the price of those lower quality assets.

Greg Campion: Okay. So obviously you got a pretty good story here. You have nine percent- ish coupons, you have very steady, predictable monthly returns like you were talking about. You have valuations that don't look super expensive relative to history. I'm just curious in terms of the major risks here. So you think about, you were just alluding to what the picture is when it comes to defaults. I think one of the concerns that you hear about is, okay, well hire for longer, great for the investor receiving the income, but more onerous for the borrower. So I'm just curious of how you're thinking about that. Is that basically the situation that you were just saying as you're CCC credits potentially an issue, everything else probably able to deal with it. And then from a portfolio management perspective, I'm curious, are you and a team dipping down into that lower rated end of the spectrum or do you feel like you can earn a sufficient return staying up in quality?

Brian Pacheco: Yeah, so I think you're right on the first part that higher rates to the extent that comes to pass or even just rates remaining where they are does impact the lower quality portion of the loan market a lot more. And if we're going to see defaults as a result of that, that's where it will come from. The what we'll call single B, double B type par credits are refinancing in the market today and you model out their cash flow and they can more than handle current rates without an issue. Leverage is reasonable, and even if you go up 50, a hundred basis points from here, not really going to change the story. So when you're constructing a portfolio of these loans, you do have to, and frankly want to have some portion of that lower quality universe in your portfolio. Some of these are good credits with bad balance sheets or they need some extra time, they need some extra liquidity. We have those capabilities, we pick our spots, we do deep fundamental credit analysis and we have entire teams of people typically staffed on these very complicated credit situations. So we do have some proportion of our portfolio there, but it's not dissimilar from the market. So if the market is less than 10%, most of our portfolios would be in that zip code.

Greg Campion: Got it, got it.

Brian Pacheco: The other thing we didn't talk about is liability management exercises. It's a big issue in loans, less of an issue in bonds just because the quality of the high yield index is much higher. But in managing this lower quality cohort, you have to be very aware of liability management situations. So for those that don't know, liability management is when loose documentation enables creative lawyers, companies and sponsors and frankly creditors to disadvantage one creditor group against another. They do this for the purpose of either capturing discount or extending runway. There are not many ways to defend yourself against adverse liability management, but there are a couple. One of them is obvious, run a really diversified portfolio. It's hard to generate alpha if you're too diversified, but that is a strategy. The other is to lean into situations that you like to those good company bad balance sheet situations, and make sure you're big enough to have an influence. So typically that means you're sitting on a steering committee and you're driving an outcome, you're driving a positive liability management outcome hopefully for the company and certainly for yourself and your investors. And some of our really best trades over the last 12 months have been liability management exercises where we were on the SteerCo and we were driving our own outcomes.

Greg Campion: Now to be on the SteerCo and driving your own outcomes, I assume you need to be a fairly large player in the space. Is that true?

Brian Pacheco: Absolutely. You have to be a large player in the space. You also have to have contacts at other funds that are large players in the space. You have to have good relationships with restructuring lawyers, restructuring advisors, and you have to have a deep network.

Greg Campion: Yeah. So clearly a great example of where having a very large established platform globally and having all the relationships with all the market participants and stakeholders that you mentioned. That's a great example of that. Well, listen, that was I think a great overview on the loans. I think you make a compelling case as to why loans are attractive today, and I think that was a very realistic overview of some of the risks that are involved as well. So I think that's really helpful. Let's transition to the bond side of things. So again, let me give the very simplistic way to look at it and then you dispel me of my simplicities and help me understand what's really going on. But so I think the common narrative out there that I see is that credit spreads are tight relative to history, and therefore maybe there's not much more value to be wrung out of high yield bonds today. So tell me, is that right? I'm sure there's more nuance, but how are you thinking about bonds generally speaking?

Brian Pacheco: Well, I'm glad you got me in here today because spreads are about 25 wider-

Greg Campion: That's true

Brian Pacheco: ...month to date. So your data might be a little stale. But yes, we are optically snug on the US side still, in the mid- 300s. Europe looks better. So if you do have a global portfolio like we do in many cases, having the flexibility to move between geographies to find the best opportunities can really create value. If you're looking at historical valuations, it's not necessarily apples- to- apples to the high- yield universe you have today. So first in terms of quality and second in terms of duration. So on the quality front we're over 50% double Bs. I'm using a global benchmark, but US and Europe are similar. It was probably 10% less than that a decade ago, and perhaps more importantly were 10% triple Cs. It was double that a decade ago. One of the important things to remember, we're using ratings as a general guideline for credit quality, but if you look at the risk to high- yield, it's below investment grade, defaults are what you're primarily concerned about. If you look at defaults 12 months in advance of a default, and I'm quoting some JP Morgan data, but this is an average over 22 years, double Bs or a company rated double B will default within 12 months, less than one- half of 1% of the time. So half our market is double Bs. Double Bs just don't default, or it's extremely rare. Single Bs, that same stat is about 2%. So most of your defaults are coming from that triple C cohort. In other words, people typically can see it coming more than 12 months in advance. And that cohort is just a very small proportion of the overall market. So spreads don't look as rich if you adjust for the quality of the index.

Greg Campion: Yep. 10 years ago, much riskier market optically, if you're looking at it from a credit rating perspective.

Brian Pacheco: The other consideration is the market is short, so duration in the US is only about 3.3 years. It's about 2. 8 years in Europe. So if you look at the spread per unit of duration, it's in the 40th percentile over the last three years, I only saw three- year data. This came from a sell- side report last week. But if you break it down, per unit of duration it's more attractive. The other thing to think about is about 25% of the market comes due in the next three years. CFOs, that's higher than typical. The reason for that is we've had this environment of suppressed interest rates, low coupons, and if you're a CFO sitting in a boardroom and you have this really low coupon, it's almost like having a really low mortgage. You're not going to rush out there and refinance it. So CFOs have waited as long as they can, and at some point they have to refinance. Even if they have a low coupon, their bonds are trading below par. They're not going to wait until the day before maturity to refinance those bonds, especially for sub- investment grade issuers. So typically CFOs don't want their bonds to go current. So current would be your bonds are still outstanding within 12 months of the maturity, and typically they'll refinance 12 to 18 months in advance of a maturity. So if you have 25% of the index coming due within the next three years, you have this strong pull to par for a pretty large portion of the index, which is coming from that refinancing activity. So yes, spreads are optically tight, different parts of the curve are more attractive than others, which is why you need an active manager to invest in the right places. But in general terms, you're still making an 8% return for a higher quality index than you've had typically. And it's a three point, it's very short. It's a 3. 3 year-

Greg Campion: Now, when you say 8% return, are you talking about the yield?

Brian Pacheco: That's a yield, and that's a yield to worst. So that's not making... Worst, if you have a low coupon, you're trading below par is typically going to be maturity. So a lot of those are going to come out ahead of the maturity. So you could argue that that's even understating the potential return, but if you have a little spread widening on the back end, you have a little pull to par effect on the front end, 8% for a high quality index over that doesn't have huge sensitivity to spread moves. Seems pretty good to us.

Greg Campion: And then in terms of, I'm going to ask you the same question I asked you for loans, which is going back to the health of the borrowers. So you're talking about CFOs needing to refinance, they've been putting it off. Now here they are, they're looking at the same data we are, they're looking at the same J- PAL speech we are. And it seems like okay, rates are probably not going lower anytime soon, so maybe they're a little bit more incentivized now to refinance their bonds. How are you thinking about that? Is it the same picture when it comes to loans where it's really only the CCC credits that are the big worries, or is there any difference or nuance when it comes to the bond side?

Brian Pacheco: Well, you bring up a good point where some of that refinancing activity, because of this new hire for longer narrative may actually be accelerated, because if spreads are reasonable from the view of a borrower, and you don't think you're going to get a massive rate tailwind, then you certainly don't want to wait until 12 months before your maturity. You're just going to hit the market while it's open and that's a better return for investors. Yes, same thing on CCCs. Even with the CCC cohort, the economic backdrop is really strong, and as refinancing takes place, those companies are refinancing into higher coupons. So it is more of a problem than it is for higher quality issuers, but not something we see that's going to cause an imminent larger than typical default cycle or larger than typical default rate, I should say. And when you think about a cycle, you think about a spike and I really don't think we're going to see a spike. Defaults have been very manageable and we expect more of the same.

Greg Campion: Got it, got it. Okay. So net- net, loans and bonds, based on what you said earlier in terms of where you all are, in terms of the allocations of your multi- asset strategies, positive stories, a lot to like on both sides, but loans seem to be an outlier in terms of value today. Am I paraphrasing that-

Brian Pacheco: I think that's right. Loans really jump off the page and it really is that simple as 75 basis points a month with not a lot of default risk in our mind. I don't think you need to overthink it.

Greg Campion: Yeah. Yeah.

Brian Pacheco: So we love loans, but high yield has its reasons for being attractive as well, and that's because you're earning a good return for a relatively short duration asset class that's higher quality than it's been in a long time.

Greg Campion: Okay. Now, I already asked you about credit quality and the potential for defaults, but let's talk about what else could derail this story. I know that you and the team are professional worriers about downside risk, and so let's talk about some of those things that you all are worried about, or at least the risk that you are really trying to actively manage. So what could derail this whole story?

Brian Pacheco: So I don't think the market is set up for a re- acceleration of inflation. So pushing cuts to the right is fine, staying on hold, so higher for longer I think is okay, but a re- acceleration that caused the Fed to actually have to go the other way and start hiking again would be problematic for risk assets. So that's something to watch.

Greg Campion: And what would be the mechanism that that would be problematic? Would it be directly impacting the health of the borrowers and their ability to manage their financial obligations, or is there something else?

Brian Pacheco: So it's through Fed policy. The Fed would hike rates in an attempt of slowing down the economy. I think history has proven that the Fed can ultimately be successful in what it wants to do, particularly if that is slowing down the economy. It's just a matter of degree. So the Fed has plenty of tools to dampen inflation, but they tend to be pretty painful for economic activity. So that's really the mechanism by which it happens. And borrowers are impacted, yes, by higher rates flowing through in terms of certainly loans immediately flowing through, bonds flowing through on a lag. But I think the bigger impact is first of all, the market reaction, that negative reaction, the impact on sentiment. So companies pull back, they don't spend. It's almost self- fulfilling. And it's the massive impact to economic activity that really hurts borrowers and hurts our market.

Greg Campion: Yeah. Anything you can do about that in terms of managing that risk or is it just-

Brian Pacheco: Sure, there's lots of things you can do if that's your base case, but it's not our base case at all. We think the economy is going to remain strong, but we do think the 500 basis point increase in rates that we've had, give or take, will have an effect. That effect is on a lag. Corporates that have locked in duration hits them on a lag. Consumers that have locked in mortgages are not feeling it, but over time, and we've seen early signs of cracks here and there, delinquencies and sort of lower income segments of the market. So I think over time you will see more of that. That's the scenario that we're positioning for rather than a rapid re- acceleration of inflation that causes the Fed to be a lot more hawkish.

Greg Campion: Yeah, makes sense. What else is out there? Anything else that is a major risk on the horizon?

Brian Pacheco: Well, if term premiums come back in a big way, I think that could be very disruptive to markets.

Greg Campion: And how do you define a term premium in the industry?

Brian Pacheco: So term premium is the amount of additional compensation you need to go out on the curve to go longer. So right now, the Treasury curve is inverted or somewhat inverted depending on what part of the curve you're looking at. But a term premium would be that curve steepening, they would call it bear steepening in the case that I'm worried about, which means the long end would go a lot higher than the short end is increasing. So term premium would increase, for example, if sentiment shifted such that there were real concerns about deficit spending. So we're running a deficit of 7% of GDP at a time when unemployment is less than 4% in an expanding economy. If we go into some sort of a slowdown or recession, that deficit is going to expand and there's a real, or I'm at least concerned that if term premiums came back in a big way, that that would be disruptive to markets.

Greg Campion: Yeah. Okay. Is there any obvious catalyst, because this is obviously something that has been a worry on and off probably for whatever, a decade or more. Is there any obvious catalyst? Is it the election or, it doesn't seem like either one of the two major candidates is calling for a big austerity packages or anything like that.

Brian Pacheco: No, definitely not. It could be, there's no catalyst. It's hard to predict these sentiment shifts or what the catalyst is for a sentiment shift. And at least I personally, and I think our team is not predicting that there is going to be real concerns around the deficit such that our markets are impacted for some period of time. Certainly it's not in our sixth to 12 or 18 month investment horizon. Could it be a big issue for the 2028 election? Definitely. Is it an issue for this election? Unlikely. But you said what could derail it, and it's the risk that the market's not positioned for is what derails things. And I think that that's another risk that the market is not positioned for.

Greg Campion: Okay. Last one. I wanted to ask you about geopolitics. We're seeing headlines every day. Some of them are pretty worrying. Is that something that's on the radar of you and your team?

Brian Pacheco: So it's definitely on the radar. Geopolitics are always an issue, but I think it'd be disingenuous to claim that it's normal. We have a hot war in Ukraine, which is right next door to NATO country. We have an armed conflict in the Middle East, very close to a hot war between Iran and Israel. So certainly geopolitics are a risk, a big risk. The challenge with positioning for geopolitics is, one, it's very hard to predict the outcome, and perhaps even more importantly, even if you could predict the outcome perfectly, it's even more difficult to predict the market's reaction to that outcome. There's been numerous examples, but the one that sticks out in my mind, and this is not a political statement at all, but in 2016, Trump was clearly the underdog and was not expected to win. And then I think what surprised people even more was that stocks rallied during the four weeks after he won. So if you had known in advance that Trump was going to be the" upset victor," I don't think investors first thought would be, well, I'm going to go out and buy stocks.

Greg Campion: Yeah. Yeah.

Brian Pacheco: So it's very challenging. I think the way that you insulate your portfolio from geopolitics is to just keep a diversified portfolio that is durable and continue to monitor the situation closely and react accordingly.

Greg Campion: Makes sense. Well, that is helpful to hear some of the big risks that are out there. Yeah, some of them are, I can imagine are very difficult to try to manage a portfolio with those in mind, but it sounds like there's some ways you can be pretty smart about it. Well, let's land the plane here. I want to thank you for joining first of all, but let me just ask you, we covered a lot of ground here, talked about loans, talked about bonds, talked about the macro background and some risks. Any parting words you'd like to leave folks with? So let's say maybe somebody has an allocation to below investment grade credit or is considering it, anything you'd like to leave them with today?

Brian Pacheco: Well, I hope I highlighted that the economy is strong, corporate balance sheets are in decent shape and all in yields are still attractive. Loans are a particularly attractive opportunity right now, but whether you're talking about loans or bonds, US or Europe, it's important to remember that these are below investment grade asset classes. You need a big team with boots on the ground doing the credit work and understanding all the nuances of these different situations to be successful in that credit selection, which is ultimately the most important driver of returns.

Greg Campion: Yeah. It all comes back to that credit analysis and credit selection.

Brian Pacheco: Yeah.

Greg Campion: Well, thank you, Brian. This has been awesome. Really appreciate it and I'm sure our listeners have as well. Thanks for joining.

Brian Pacheco: Thanks for having me.

Greg Campion: Thanks for listening to or watching this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast at B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.