Investing in High Yield Through the Economic Cycle

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  • 07 mins 47 secs
High Yield portfolio manager David Cole explores how recent dynamics affected the credit cycle and potential opportunities and risks going forward.


MFS Investment Management

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Disclosure at start of video:

The views expressed are those of the portfolio manager as of August 25, 2020, and are subject to change at any time. These views do not necessarily reflect the views of MFS or others in the MFS organization.


Keep in mind that all investments, including mutual funds, carry a certain amount of risk including the possible loss of the principal amount invested.


Past performance is no guarantee of future results.


David Cole: Hi, I'm David Cole, co-portfolio manager of MFS's high yield strategies. Thanks for taking the time to watch this video. We believe that a well-diversified portfolio should include a long-term strategic allocation to high yield, especially today as most other fixed income markets offer near zero yield. We also believe that careful top-down and bottom-up risk management can dampen some of the volatility and drawdown risk inherent in the asset class, and thereby strengthen long-term compounded returns. Specifically, we seek to manage overall high yield portfolio risk in tune with credit cycles, while allowing our bottom-up credit research to populate our strategies with sectors and credits with favorable long-term prospects. Let's start with how we view credit cycles and what that means for portfolio construction.

                                                            Slide one breaks down the credit cycle into three phases, expansion, downturn, and recovery. We'll begin with the expansion phase of the cycle, which can last multiple years. During this period, companies and investors extrapolate favorable economic conditions and take on greater financial risks. Companies use their balance sheets to drive earnings growth, while investors seek higher yielding opportunities to keep up with benchmarks. As late cycle bullishness narrows credit spreads and compresses risk measures, we upgrade credit quality across our strategies. We significantly underweight lower quality tiers and more cyclical sectors. Eventually, these credit risks accumulate until an exogenous event disrupts the status quo, ending the expansion phase.

                                                            In the current cycle, this clearly started in mid-February as the COVID virus spread across the globe. Quickly, the market environment deteriorates and the cycle transitions to the downturn phase. This period tends to be short in duration, but painful in losses. Over-leveraged companies fall into financial distress. Investors' risk preferences change quickly as fear takes over from greed. Trading liquidity evaporates and credit spreads spike higher. This was the market environment in March when high yield spreads increased by over 700 basis points in the span of weeks.

                                                            The key to outperforming in this environment is simple. Be prepared. Be prepared in advance for the cycle to change and change violently. Defensively positioned portfolios may underperform at the expansion's tail end, but would recoup any shortfall and more once the cycle turns. We seek to capitalize on the opportunities presented by this market dislocation by adding lower quality credit, and more cyclical exposure to the portfolios. At significant discounts to par, low quality high yield more than adequately compensates investors for the risk. This is where we rely on our team of experienced analysts who strive to identify the most attractive investments, focusing on credits and sectors with more favorable long-term growth prospects and lower default risk.

                                                            The downturn phase typically ends with an aggressive economic policy response. Volatility ebbs and the market and through the recovery phase. Borrowers focus on repairing balance sheets by retaining cash flows, enhancing liquidity, and pursuing non-core asset sales. Tactical investors flow back into the asset class, driving spreads lower. Market recovery ensues as refinancing risk dissipates. At this point in the cycle, we aspire to have MFS high yield portfolios near maximum risk exposure.

                                                            Turning to slide two, you can see how quickly credit spreads have recovered. Swift fiscal and monetary policy reactions to the pandemic truncated this at credit cycle, at least so far. While the full extent of the economic damage has not yet been fully accounted, the pace of market repair has been impressive. In the span of 60 trading days high yield credit spreads went from 550 basis points, peaking at 1100 basis points before recovering back to 550 basis points. Post-GFC ,it took the higher market over two years to stage a similar recovery.

                                                            Companies use the spread recovery to buy time, showing up damaged balance sheets by bolstering cash positions. Encouraged by central banks, investors have been highly receptive to new issuance. As a lagging indicator we expect high yield default rates to continue moving higher through 2020. Despite this, our outlook is favorable over the long-term for high yield. We expect some industries to remain challenged by structural and cyclical forces and advocate selectivity rather than a heavy overweight to low quality credits, which would remain vulnerable in an uneven economic recovery.

                                                            Lastly, we conclude on slide three by highlighting current MFS portfolio positioning in selected sectors that hopefully represent broader portfolio themes. Our analyst team seeks to uncover the best risk adjusted opportunities in the market with a focus on sustainable long-term performance. The chart on the left shows our active exposure versus benchmark for the packaging and energy sectors. Clearly, we favor packaging over energy and have for a number of years. Similarly, the chart on the right shows active exposure of the technology and legacy telco segments. You'll notice that we transitioned to a fairly consistent overweight in tech over the past few years.

                                                            Packaging and technology from our perspective share common characteristics that are well represented in our portfolios. We tend to favor stable businesses run by management teams who value balance sheet strength and consistently generate free cashflow. Consumer-oriented packaging companies and recurring revenue tech businesses share those traits. On the flip side, MFS portfolios have been consistently underweight energy and legacy telco sectors. We think the long-term outlook for both industries is unattractive as both segments face disruptive threats, renewable energy for oil and gas companies, and wireless and telco cable for the telco segment. In addition, both sectors have allocated capital poorly over the longterm. These sector allocations represent our investment approach, which focuses on areas most likely to deliver long, strong through-cycle returns for clients.

                                                            To conclude, in a low yield world, we think the high yield asset class offers investors an attractive risk return opportunity provided the downside risks are actively managed. To steal from the saying about history repeating itself, credit cycles don't always repeat, but they often do run. We also think that overall risk management combined with careful fundamental credit analysis can result in high yield portfolios better suited to navigate the asset classes, volatility, thereby producing better results for clients. Thanks again for your interest and hopefully speak with you again soon.





The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.


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