February 2019

1

A market dominated by volatility and dramatic headlines—if this environment feels familiar, perhaps it’s because it is.

Since the 2008 financial crisis, the high yield market has experienced several risk-on/risk-off periods. From the sovereign debt crisis in 2011 and the taper tantrum in 2013, to the energy and commodity shock in 2015 and, most recently, the headline-induced turbulence in the fourth quarter of 2018, this market has experienced numerous risk flare-ups, lasting anywhere from a few weeks to several months.

Throughout these periods, a look beyond some of the more negative headlines revealed what has actually been a relatively healthy market. Corporate fundamentals, overall, remained stable. Defaults hovered near all-time lows. And global growth was largely supportive.

It’s not altogether surprising, then, that all of the abovementioned dips were followed by periods of recovery and gains. Take the fourth quarter of 2018, for example. As equities experienced a near bear-market drop,1 parts of the high yield market saw spreads widen to a level that implied distress in excess of that experienced in the post-Lehman period, painting a significantly more bearish picture than we currently assume.

All of this said, economic cycles by nature have an end date. Downturns do come, and we are undoubtedly closer to one today than we were three or five years ago, albeit one that is likely less severe than the financial crisis. With that in mind, this piece takes a close look at the high yield markets and outlines five key takeaways for investors in the months ahead.

1. A condition in which security prices fall 20% or more over, typically over a two-month period.

| February 2019

1—

TODAY IS DIFFERENT THAN 2007

2—

HIGH YIELD HAS WEATHERED

RECESSIONS FAIRLY WELL

3—

VALUATIONS CONTINUE TO COMPENSATE

INVESTORS FOR RISK

4—

TIMING THE MARKET IS HARD

TO DO

5—

SECURED ASSETS MAY BE A HIDDEN GEM

HIGH YIELD

FIVE TAKEAWAYS for the

MONTHS AHEAD

February 2019

2

2. Source: J.P. Morgan. As of December 31, 2018.

SOURCE: S&P GLOBAL, BARCLAYS, J.P. MORGAN. AS OF DECEMBER 31, 2018.1. 2007; 2018.

FIGURE 1: TODAY’S MARKETS APPEAR LESS RISKY OVERALL VS. 2007

2006–2007 2017–2018

U.S. HY Bonds M&A/LBO Volume 32% 24%

European HY Bonds M&A/LBO Volume 31% 25%

U.S. HY Bonds CCC (% of Market)¹ 15% 11%

European HY Bonds CCC (% of Market)¹ 10% 5%

2007 Today

Bridge Risk (Total Loans and Bonds) $330 billion $85 billion

CLO Warehouses $40–$50 billion $15–$20 billion

Investor Leverage $250 billion (8–10x) <$90 billion (3–4x)

“ …when the market does experience a downturn—as it inevitably will at some point—we expect it to be much less severe than the

2007–2008 financial crisis…”

Numerous headlines this year have raised concerns about the high yield markets. While we agree that the high yield bond and loan markets will experience some level of distress during a recession, we think a comparison between today’s markets with the pre-financial crisis markets is somewhat misleading, for a few key reasons.

As suggested in FIGURE 1, the market today appears to be less risky than it was in 2007. For one, the volume of leveraged buyouts—acquisitions that involve a significant amount of borrowed money or outside capital, typically the riskiest deals—is lower today across the U.S. and Europe. In addition, CCC credits make up a smaller percentage of the market today versus 2007.

More importantly, there is also less systemic risk in the markets today, as indicated by lower bridge risk, CLO warehouse exposure and investor leverage. In the event of a downturn, lower investor leverage, in particular, could help prevent some of the forced selling that we believe was a major contributor to the large drawdown in 2008.2

The global high yield bond market has also evolved since 2007 from a composition standpoint. Today’s market is made up of

large, diverse companies that on average generate hundreds of millions of EBITDA and represent all areas of the global economy, from healthcare and information technology to media, telecom, industrials and energy.

Finally, it’s worth pointing out that market commentators have been speculating about the end of the credit cycle for some 18 months or more. This constant narrative has had an erosive effect on the risk appetite of both investors and issuers, evidenced in 2018 as a number of issues that were perceived as higher risk were pulled from the market.

While a slowdown in earnings growth is possible, or even probable, going forward, high yield issuers today are generally reporting decent earnings and cash flow, and we expect default rates to remain low. While there are certainly exceptions in today’s market, we are not seeing widespread aggressive deal structures or highly speculative corporate behavior that typified the late cycle prior to 2008.

Taking into account all of these factors, when the market does experience a downturn—as it inevitably will at some point—we expect it to be much less severe than the 2007–2008 financial crisis and more in line with pre-crisis downturns.

1—

TODAY IS DIFFERENT THAN 2007

February 2019

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Global GDP is expected to continue growing, albeit at a slower pace, through at least 2020, according to the International Monetary Fund. Nonetheless, the possibility of a recession continues to weigh heavily on many investors’ minds. It is worthwhile, then, to examine the performance of high yield during different recessionary periods in recent history.

As FIGURE 2 shows, high yield has performed relatively well through periods of negative GDP growth. Investors who stayed invested in high yield through periods of volatility—and even economic decline—have been rewarded with attractive long-term returns. Even taking into account negative post-financial crisis performance, a buy-and-hold strategy in European and U.S. high yield bonds to date would have delivered annualized returns above 7%—only slightly underperforming U.S. large-cap equities and materially outperforming European stocks.

Going back further, over the last 20 years high yield performance has been negative in only five years. Prior to 2018, every one of those negative years was followed by a positive year (FIGURE 3). This suggests that mild recessions, which tend to keep defaults measured and spreads wide, are not all bad for the asset class when viewed over a long period of time.

As an asset class, high yield is different than equities in that it doesn’t require strong economic growth to perform well. Rather, what matters most in high yield is an issuer’s ability to continue to meet the interest payments on its outstanding debt obligations. Slow GDP growth, or even a short period of mildly negative growth, is unlikely to drive a significant increase in defaults. Indeed, the cash coupons of the asset class tend to dampen the volatility associated with negative price action during periods of economic sensitivity, leading to more attractive Sharpe ratios3 over time (FIGURE 2).

SOURCES: BLOOMBERG (EQUITY INDEX RETURNS SHOWN ARE GROSS DIVIDENDS); BANK OF AMERICA MERRILL LYNCH. AS OF DECEMBER 31, 2018. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

FIGURE 2: HIGH YIELD BONDS: POSITIVE PERFORMANCE WITH LESS VOLATILITY

HIGH YIELD BOND RETURNS (JULY 2008–DECEMBER 2018)

European High Yield Bonds U.S. High Yield Bonds S&P 500 ESTOXX 50

-100

Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18

200

150

100

50

0

-50

ANNUALIZED (SHARPE RATIO)

+8.99% (0.57)

+7.79% (0.71)GREAT

RECESSIONNEGATIVE

GDP IN EUROPE +7.17% (0.67)

+2.91% (0.14)

SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF DECEMBER 31, 2018. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

FIGURE 3: NEGATIVE YEARS FOLLOWED BY POSITIVE PERFORMANCE

60%

50%

40%

30%

20%

10%

0%

-20%

-10%

-40%

-30%

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2.6

-5.8

3.0

-1.3

28.1

11.2

2.9

10.9

2.3

54.5

-25.5

13.7

4.4

16.3

7.6

2.8

-3.9

16.9

7.5

-2.0

GLOBAL HIGH YIELD BOND RETURNS (1999–2018)

3. A measure of return per unit of risk.

2—

HIGH YIELD HAS WEATHERED RECESSIONS FAIRLY WELL

February 2019

4

As we look across the high yield markets today, we continue to see opportunities in both the U.S. and Europe. While corporate fundamentals may experience some weakness going forward, they remain relatively stable on both sides of the Atlantic, in our view. Defaults are also low, and have hovered around 1% in Europe and 2% in the U.S. over the last few years. Looking ahead over the next year, we may see defaults rise above these levels, particularly across a few of the more troubled sectors. The ability to proactively navigate a period of higher defaults is where we think active managers can add significant value in the high yield markets.

Recently, technical factors have caused spreads to widen beyond what fundamentals would suggest, particularly in Europe. European single-B bonds, for example, are currently trading with a spread over 650 basis points (bps), more than 150 bps wider than the average over the last five years.4 In the context of a low default outlook, these spread levels suggest that investors are being more than fairly compensated, relative to other points in the cycle, for the amount of risk they are taking.

For context, this level of risk premium suggests investors are currently being compensated for default levels in excess of what was experienced in the year following the bankruptcy of Lehman Brothers or the Sovereign Debt Crisis, which in our view appears excessive.

4. Source: Bank of America Merrill Lynch. As of December 31, 2018.

3—

VALUATIONS CONTINUE TO COMPENSATE INVESTORS FOR RISK

4—

TIMING THE MARKET IS HARD TO DO

Investors have become so familiar with the post-crisis risk-on/risk-off loop that many are now looking for the sell-off or entry point to jump in. But trying to time entry or re-entry into the market is challenging at the best of times, and currently even more so with the number of potential risks on the horizon. As we look ahead over the coming months, we expect that the ongoing risks and uncertainty prevalent today will continue to grab headlines and influence markets.

Technical factors—such as flows into and out of retail funds and CLO issuance—may also drive additional, perhaps even significant, market movements. It can be very difficult to time investment decisions around these short-term movements—for example, during the 2013 taper tantrum and the 2016 Brexit vote, the entry point came and went relatively quickly. In our view, this is one of the strongest arguments for considering high yield a strategic, rather than tactical, allocation in a well-diversified portfolio.

“...trying to time entry or re-entry into the market is challenging at the best of times, and currently even more so with the number

of potential risks on the horizon.”

February 2019

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5—

SECURED ASSETS MAY BE A HIDDEN GEM

One way investors can achieve long-term, through-the-cycle exposure to high yield is through a multi credit approach that invests in bonds and loans across both the U.S. and Europe. While the corporate credit markets in these regions—whether bonds or loans—tend to be highly correlated over the long term and exhibit similar risk/return profiles, these markets are driven by different factors that, historically, have caused them to outperform or underperform one another at different times.

A multi credit approach can be particularly valuable, in that it can provide managers with the flexibility to pivot to the regions or sub-asset classes that they believe offer the best relative value at any given point in time—and away from those where the risks appear too high.

SOURCE: BANK OF AMERICA MERRILL LYNCH. AS OF DECEMBER 31, 2018.PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

FIGURE 4: THERE IS ALMOST NO PRICING DISTINCTION TODAY BETWEEN SECURED AND UNSECURED HIGH YIELD BONDS

Global High Yield Bonds Global Senior Secured Bonds

250 bps

550 bps

500 bps

400 bps

450 bps

350 bps

300 bps

Dec-18Dec-17Dec-16 Jun-17 Jun-18

SENIOR SECURED AND HIGH YIELD BOND HISTORICAL SPREADS

In the later stages of this prolonged credit cycle, one area that may appeal to some investors is senior secured assets. While senior secured bonds and loans are not recession-proof, they are higher in the capital structure than unsecured bonds and can offer investors greater protection from principal loss in the event that market default rates rise. Senior secured bonds often sit pari pasu with senior secured loans in a company’s capital structure. This means that in the event of default, senior secured bondholders are positioned alongside loan investors for a potential recovery.

Recovery rates for senior secured assets have historically been higher than those of traditional, unsecured bonds because the debt is secured by specific issuer collateral. Practically speaking,

this suggests that in the event of default, senior secured lenders are in a favorable position, relative to unsecured creditors, to drive the debt restructuring in a way that allows the greatest amount of principal investment to be recovered.

Looking at the markets today, there is almost no pricing distinction between secured and unsecured high yield bonds (FIGURE 4). We think this is due largely to the sustained period of low default rates in both the U.S. and Europe, as well as to the markets’ general inefficiency at pricing risk. While investors’ needs span a very wide spectrum, for some, these spread levels may represent an attractive opportunity, particularly given the significant potential benefit of having asset security amid an economic slowdown.

February 2019

6

Martin Horne is Head of Barings’ Global High Yield Investments Group and European High Yield Investments Group. Martin is also Chairman of the European High Yield Investment Committee and Vice Chairman of the Global High Yield Allocation Committee. His responsibilities include portfolio management for several of the firm’s loan and multi-strategy portfolios. Martin has worked in the industry since 1996 and his experience has encompassed the mid cap, structured credit, investment grade and leverage finance markets. Prior to joining the firm in 2002, Martin was a member of the European Leverage team at Dresdner Kleinwort Wasserstein where he focused on lead arranging and underwriting senior, mezzanine and high yield facilities for financial sponsor driven leverage buyouts throughout Europe.

MARTIN HORNEHEAD OF GLOBAL HIGH YIELD INVESTMENTS

David Mihalick is Head of Barings’ U.S. High Yield Investments Group, Chairman of the U.S. High Yield Investment Committee, a member of the Global High Yield Allocation Committee, and a portfolio manager on various high yield strategies. Prior to his current role, David served as Head of Baring’s U.S. High Yield Credit Research Group where he was responsible for directing the research efforts of over 25 analysts. David has worked in the financial services industry since 2004. Prior to joining the firm in 2008, he was a Vice President with Wachovia Securities Leveraged Finance Group. At Wachovia he was responsible for sell-side origination of leveraged loans and high yield bonds to support both corporate and private equity issuers.

DAVID MIHALICKHEAD OF U.S. HIGH YIELD INVESTMENTS

Conclusion From trade wars and Brexit to central bank posturing and recessions, there is no shortage of risks facing today’s markets. As we consider high yield in the context of today’s turbulent environment, there are five key takeaways we think are worth considering in the months ahead:

• Today is Different Than 2007: There is much less systemic risk in the market today, in our view, and the underlying credit quality of issuers is relatively healthy. When we do experience a downturn, we do not expect it to be as severe as the financial crisis.

• High Yield has Weathered Recessions Fairly Well: High yield has stayed the course through periods of slow and negative GDP growth, suggesting mild recessions are not all bad for investors with a long-term perspective. This may be because the asset class doesn’t require strong economic growth to perform well—what matters more is an issuer’s ability to repay money invested, and slow or mildly negative growth will not always affect that.

• Valuations Continue to Compensate Investors for Risk: Current spread levels in the context of a low default outlook suggest that investors are being fairly compensated, relative to other points in the cycle, for the amount of risk they are taking.

• Timing the Market is Hard to Do: In an environment characterized by uncertainty, we believe investors can benefit from considering high yield a strategic, rather than tactical, allocation. A multi credit approach is one way investors can achieve long-term, through-the-cycle exposure to the asset class.

• Secured Assets May be a Hidden Gem: Senior secured bonds and loans, though not recession-proof, are higher in the capital structure than unsecured assets and can offer investors greater protection from principal loss in the event that market default rates rise.

Above all, we believe a credit-intensive, global approach to high yield is key. At Barings, we leverage the expertise of our large team to select credits that can withstand headwinds and hold up through credit cycles. We also take an active approach to investing, which allows us to move away from credits that exhibit fundamental weakness in favor of healthier issuers. Our global team—consisting of more than 70 investment professionals across the U.S. and Europe—is in constant communication, which we believe puts us in a good position to identify and capitalize on relative value opportunities as they arise across geographies.

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