In a year when stocks and bonds have been hammered and some corners of the U.S. investment-grade corporate bond market suffered percentage losses in the mid-teens, perhaps one of the best things to say about the U.S. high-yield bond sector is that on the whole it performed slightly better, suffering only low double-digit losses while producing yields that were roughly three or four percentage points higher versus investment-grade bonds.
That sounds like a backhanded compliment, but it’s a bit ironic that the riskier corporate junk bond category held up better than the supposedly safer investment-grade variety, particularly those securities with longer-dated maturities. Then again, maybe it’s not so ironic.
“High yield is in the Goldilocks area of fixed income where there’s not too much duration and not too much credit risk,” offers John McClain, co-portfolio manager of the BrandywineGlobal High Yield Fund. “When looking across the fixed-income landscape right now, if you believe we won’t go into a recession, then high yield is the cheapest part of public fixed income.”
Despite the recession fears now that the Federal Reserve has hiked interest rates to fight inflation, McClain maintains that the high-yield sector offers some advantages for fixed-income investors.
“If you think rates will get out of whack and go much higher, two things will happen. One, traditional high-quality fixed income, the so-called less risky part of the fixed-income market, will continue to have a larger drawdown than the high-yield market. In addition, high yield going into and coming out of a recession does better than equities.”
But the high-yield debt market isn’t monolithic, and the trick is finding the right subsets as market conditions evolve. McClain and his partner, Bill Zox, have forged an impressive track record with a high-yield strategy that launched in limited partnership form in late 2014, and two years later went out to a wider audience when the BrandywineGlobal High Yield Fund launched.
The fund’s Class I shares have been a top-quartile performer in Morningstar’s high-yield bond category during the three- and five-year periods through June 15, finishing fourth overall in the three-year period among its category peers. Even better, Morningstar ranked it the best performer among 566 competing funds during the five-year period. Elsewhere, Lipper named the fund’s IS share class the best among high-yield bond funds based on risk-adjusted performance for the five-year period ending November 30, 2021. (The IS share class, which is aimed at pensions, endowments and corporate 401(k) plans, has a slightly lower expense ratio and slightly better performance numbers than the I share class available to investors on brokerage platforms.)
Part of the fund’s success lies in its nimble approach, including the managers’ ability to step into investment-grade bond territory when conditions call for it. The non-investment-grade (or high-yield debt) category comprises bonds issued by companies deemed to have a greater risk of defaulting on their interest payments or principal. Non-investment-grade bonds are rated lower than “BBB-” or “Baa3” by the major rating agencies. Because they’re considered riskier than investment-grade bonds, they have to pay higher coupons to attract investors. The higher the risk, the greater the yield.
According to a report by Morningstar analyst Mike Mulach, the BrandywineGlobal High Yield Fund responded to the 2019 credit rally by raising its investment-grade bond exposure to 20% by the end of that year, its highest level since the strategy’s inception. That positioning helped the fund weather the worst of the Covid pandemic fallout in the first quarter of 2020, and McClain and Zox upped the fund’s investment-grade exposure even further by quarter’s end.
But after the fund took advantage of the tailwinds from the Fed’s massive bond-buying program and the gradual economic recovery during the second half of 2020, Mulach noted that valuation concerns caused the management team to change course by allocating out of higher-rated, longer-duration bonds and into lower-rated bonds with shorter maturities and higher yields.