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Yield resilience

10 MINUTES WITH…ECE UGURTAS BY JAMES SMITH

High-yield bonds can offer provide protection for fixed-interest portfolios in the expected rising interest rate and inflation environment, according to Barings’ Ece Ugurtas. She has taken the group’s high-yield bond fund to the head of its sector over three and five years to the end of May and remains positive on her asset class.

After two years of outperformance for high yield, Ugurtas cites key reasons this run can continue. “We expect to benefit from further spread compression, albeit not to the same extent as in recent years,” she says. “Elsewhere, default rates have fallen sharply and we predict they trend downwards. Demand will also to continue to exceed supply, as high yield remains attractive to investors seeking income in the ultra-low-interestrate environment.”

Current default rates are 2.4 per cent, with S&P forecasting 1.8 per cent by the year-end and Moody’s 1.4 per cent.

In addition to return potential, she also highlights the defensive quality of high-yield paper in certain conditions, with rising interest rates and inflation not generally conducive for fixed income.

Historically, however, high yield has tended to be more resilient than most in these conditions, as prices are more sensitive to the credit quality of issuers than base rate changes.

“Modest economic growth in the US, which is high yield’s home market, improving corporate balance sheets, strong inflows and a downward trend in default rates contributed to a successful rebound for the asset class during 2010,” adds Ugurtas.

“We could see a repeat of these fundamentals in 2011 and this is a supportive environment for investors. Valuations for high-yield debt also look favourable on an absolute and relative basis to other debt assets, such as US treasuries, UK gilts and investment-grade corporate paper.”

Ugurtas says the Barings’ fixed-income process is relatively unique, in that it relies on top-down scenario analysis to model possible market responses to a variety of economic outcomes. “Each scenario is populated with macroeconomic forecasts, enabling us to develop predictions for yield curves, currencies, swap spreads and credit spreads,” she says.

“By comparing the range of forecasts with actual market levels, we can judge whether an asset is cheap or expensive given the scenarios the market may move toward over the next few months.”

On the macro front, Barings is currently considering various circumstances in its scenarios, namely US recovery, a global inflation shock and a confluence of shocks leading to global slowdown.

“With geopolitical concerns currently driving bond markets, we expect a degree of volatility in the near term as events in Japan, the Middle East and Africa continue to unfold,” says Ugurtas.

“So far, the high-yield market has proved resilient to recent shocks and has continued to post positive returns. Corporates have seemingly learnt the harsh lessons of the financial crisis and are increasingly using new proceeds to refinance debt and strengthen balance sheets.

“As such, default rates have fallen sharply and with around 90 per cent of firms in the high-yield universe now freecashflow-positive, we expect this trend to continue over 2011. Crucially, markets continue to price in an excessive default rate and this is creating good opportunities, particularly in the B and BB market bands.”

Against this background, she has 90 per cent of the fund invested in global high yield, 5 per cent in local currency emerging market debt and the remainder in cash/ investment-grade issuers.

“We have built up a position in the lower end of the global high-yield credit spectrum where we believe most value remains,” says Ugurtas. “Sector-wise, we have concentrated exposure in energy, services and consumer-related areas and expect these to outperform in a global growth environment with higher inflation and commodity prices.”

Amid recent volatile conditions, the team took a defensive position in 2008 – with low duration and diversifying into investment-grade credit and short-dated local currency EMD – which protected the fund from the vicious sell-off in high yield. “We built up our high-yield stake from 20 per cent in the first quarter of 2009, which enabled us to capitalise upon two subsequent strong years of performance,” adds Ugurtas.
“For this year, our constructive view on high yield is reflected by our large allocation through US and European markets and trading has been in view of profittaking and reinvestment into names with compelling valuations.”

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