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Off-The Benchmark Approach in High Yield

Stockholm (HedgeNordic) – After years of extremely low interest rates, fixed income has once again emerged as an attractive asset class. While many segments of the fixed-income universe have regained appeal, Ville Iso-Mustajärvi, portfolio manager at Finnish pension insurer Veritas, observes a notable caveat in the current environment: tight spreads across many credit carry segments, especially in US high yield. However, Iso-Mustajärvi points out that the relatively narrow average spreads hide “a fair amount of dispersion, which could represent a meaningful source of opportunity.”

“The fixed-income universe is obviously more interesting, with some parts of the world offering positive real returns on bonds along high nominal rates,” reiterates Ville Iso-Mustajärvi, who has been working at Veritas for 15 years. He stresses the importance of real returns, stating that “nominal returns are of little help if capital loses purchasing power.” However, Iso-Mustajärvi highlights a drawback of the current environment: “tight spreads in several credit carry segments, particularly US high yield and, to a lesser extent, European high yield.” 

“This asymmetry arises from spreads compensating only for a limited amount of potential future credit losses and offering very little price return upside, reducing the best case to more or less harvesting the carry.”

Ville Iso-Mustajärvi, portfolio manager at Finnish pension insurer Veritas.

With spreads on the tight end, “the attractiveness of credits is twofold. While they offer real yields, the spread situation introduces some asymmetry,” says Iso-Mustajärvi. “This asymmetry arises from spreads compensating only for a limited amount of potential future credit losses and offering very little price return upside, reducing the best case to more or less harvesting the carry.” In negative outcomes, however, the drawdowns from current tight levels can be very substantial, according to Iso-Mustajärvi.

The Beauties of High-Yield Bonds

Despite the relatively unattractive asymmetry, Iso-Mustajärvi underscores one short-term appeal of higher-yielding credits. “The beauty of the higher yielding credits in this environment lies in the fact that the risk-free component and spreads tend to move in opposite directions.” This dynamic becomes particularly relevant in a mild economic downturn coupled with expansionary monetary policies. “You have a built-in diversification mechanism, at least to some extent, in a mild market downturn. This mechanism can now work as there is room for interest rates to go down,” he explains, noting that such built-in diversification was not necessarily present in the environment of low or negative interest rates.

The longer-term appeal of high yield, according to Ville Iso-Mustajärvi, lies in the potential to generate returns close to those of equities with substantially less volatility. He further emphasizes that “investors need to make fewer assumptions about this asset class because a significant portion of the returns comes from contractual yield.” In addition to the lower level of assumptions required to estimate the potential return from high yields, Iso-Mustajärvi also points out that high-yield bonds “are both capped on the upside in terms of price appreciation and also capped on the downside as well.”

“Investors need to make fewer assumptions about this asset class because a significant portion of the returns comes from contractual yield.”

Ville Iso-Mustajärvi, portfolio manager at Finnish pension insurer Veritas.

“When things go sour, such as during the COVID crisis, and bonds start trading at 70s or even below on the dollar,” elaborates Ville Iso-Mustajärvi, “the distance to recovery value, even under dire circumstances, is substantially smaller than it was at the hundred.” During times of distress, this inherent downside protection is complemented by “skyrocketing spreads in excess of 1000bps and substantial room for price appreciation,” according to Iso-Mustajärvi. “This is not to suggest that equities should be avoided, but rather that credit can offer a robust complementary way to invest counter cyclically.”

Fair Amount of Dispersion

The fixed-income portfolio of Veritas constitutes approximately a quarter of the total portfolio, which “leans quite heavily towards all kinds of credits or higher carry instruments.” The high-yield segment represents roughly mid-single digits of the total portfolio, which falls on the lower end of Veritas’ historical allocation range to this asset class. This lower allocation reflects the challenge of insufficient spreads to adequately compensate for associated risks.

Despite historically tight average spreads, “there is a fair amount of dispersion that comes from certain distinct risks, which can be a meaningful driver of opportunity,” according to Iso-Mustajärvi. “What has been rallying the most, on average, is the more liquid, easy-to-access parts of the market,” he points out. There is slightly more pickup for investors in the more niche segments such as Nordic high yield or smaller issues. “This tends to be the case during bull runs, where investor flows drive the market and the fringe or niche assets experience a light delay.”

“One cannot just look at the spread levels and say this is tight and I’m gonna sell out and wait in cash. No one can afford that. Investors like us need the carry.”

Ville Iso-Mustajärvi, portfolio manager at Finnish pension insurer Veritas.

Despite operating in an environment of tighter spreads, “you still do get the carry,” notes Iso-Mustajärvi, “even though the price return component may be uncertain in terms of potential gains.” Iso-Mustajärvi also points out that this type of ‘tighter spread’ can persist for quite some time if the economic backdrop should remain constructive. “One cannot just look at the spread levels and say this is tight and I’m gonna sell out and wait in cash. No one can afford that. Investors like us need the carry,” emphasizes Iso-Mustajärvi.

Instead, investors can seek to enhance returns by exploring less accessible segments of the credit market, where better value opportunities may exist. “And particularly for an investor of our scale, with an investment portfolio of only €4.5 billion, we are virtually never constrained by capacity. This presents a significant opportunity for us to add considerable value.”

Off-The Benchmark Approach

Transitioning entirely off-benchmark, Ville Iso-Mustajärvi and his team at Veritas allocate approximately three-quarters of their high-yield exposure to Europe, in stark contrast to global benchmark indices which typically allocate around 20 percent to Europe and the remainder to the US. “We have completely reversed our exposure because we believe we are paid substantially better for duration-adjusted rating risk in Europe,” explains Iso-Mustajärvi. “I find the value significantly superior on the European side. For instance, if spread levels at the US index stand at 338 basis points, the equivalent index in Europe is 351.”

“Spread levels of European single Bs are around 430 basis points, while US single Bs sits at 309 basis points. This signifies over 100 basis points of additional spread available in Europe, typically across slightly shorter maturities.”

Ville Iso-Mustajärvi, portfolio manager at Finnish pension insurer Veritas.

However, spread levels at the index level are partially misleading, notes Iso-Mustajärvi, “as the composition of the indices has been changing.” The differences in the exposure to double B and the presence of triple C securities significantly influence this difference in spread levels. “I prefer to focus on single Bs, which I consider the heart and soul of the high-yield market,” says Iso-Mustajärvi. Looking at single B indices helps to mitigate the impact of compositional changes, which underscores the current appeal of European high yield versus US high yield. “Spread levels of European single Bs are around 430 basis points, while US single Bs sits at 309 basis points. This signifies over 100 basis points of additional spread available in Europe, typically across slightly shorter maturities,” notes Iso-Mustajärvi. 

“Taking these factors into consideration, I firmly believe that Europe currently offers substantially better value.” Additionally, Nordic markets provide a slight pickup compared to the more liquid segments of the European markets. “The reason for this added value may be attributed to their slower moving and lower liquidity features of the market, resulting in less flow-driven price discovery,” explains Iso-Mustajärvi. “However, this also explains why I am not inclined to overweight them entirely, as they are slower moving and less liquid.”

Manager Selection

Veritas primarily accesses the high-yield universe through external managers, with Ville Iso-Mustajärvi employing a distinct approach to manager selection. “The core of our allocation is what most would call multi-asset credit funds,” explains Iso-Mustajärvi. Veritas typically selects managers with maximum flexibility in terms of investment securities and sub-asset classes, allowing them to seize the best opportunities across instruments such as sub-investment credit, loans, bonds, CLOs, and occasionally preferred equity.

“The core of our allocation is what most would call multi-asset credit funds. These managers have virtually total freedom to navigate and identify the best value within these different instruments.”

Ville Iso-Mustajärvi, portfolio manager at Finnish pension insurer Veritas.

“These managers have virtually total freedom to navigate and identify the best value within these different instruments,” notes Iso-Mustajärvi. This approach, utilized by Veritas for over a decade, grants the pension insurer much more flexibility in pursuing relative value opportunities. According to Iso-Mustajärvi, these opportunities are particularly abundant in Europe due to constraints such as restrictions on buying CLOs for Solvency II reasons, limitations on loans for retail investors, and illiquidity issues preventing certain Central European investors from acquiring Nordic assets. Even for investors with broader mandates, there are often “neatly defined mandates, leading to occasional mispricing between different instruments, especially within capital structures,” explains Iso-Mustajärvi. “A flexible, relatively concentrated credit mandate enables us to capitalize on these opportunities.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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