Where's high-yield going? An interview with Vanguard's Michael Chang
February 17, 2023
February 17, 2023
Michael Chang, senior portfolio manager for Vanguard's Fixed Income Group high-yield credit team, discusses the high-yield market today, where opportunity lies, and how his team's patient, disciplined approach may benefit from attractive entry points to come. Chang manages the Vanguard sleeve of Vanguard High-Yield Corporate Fund, and the high-yield portions of Vanguard Core-Plus Bond Fund and Vanguard Multi-Sector Income Bond Fund (which was launched on January 26). Chang and his team are responsible for almost $10 billion in assets.
2022 was a rough year for fixed income in general and the high-yield corporate sector was no exception. How attractive is high-yield today, in your view, and why? Where do you expect the high-yield market is headed?
High-yield valuations aren't that attractive right now and yet there are three reasons to not be overly bearish. First, when taking a broad look at fixed income opportunities, yields are much more attractive in high-yield than they were a year ago, which gives us a cushion against volatility. Second, while the fundamental backdrop continues to deteriorate, our starting point on fundamentals is quite strong. And third, while valuations don't look very compelling, selection opportunities are very high.
We've seen a lot of volatility in 2022 translate into a lot of dispersion—which means the market is pricing in the risk of riskier credits by making those bonds cheaper—within the high-yield market. Dispersion creates a lot of opportunity to add value via security selection. This third point contrasts with what we saw earlier in 2022, when most bond yields were rich and trading within a tighter range of values.
Predictions for a 2023 recession in the U.S. are on the rise. What's different about this high-yield corporate bond market when compared with what we experienced at the start of the global financial crisis (GFC) in 2007?
While high-yield isn't a market that usually does well in a recession, I think there are reasons to expect it should fare better this time around, particularly when compared with 2007. Overall, high-yield is better-positioned today. The composition of outstanding debt is at a much higher quality level than what we saw just prior to the global financial crisis. Bonds that are rated BB make up a much larger portion of the market now, while those rated CCC make up a much lower proportion.
In the run-up to the GFC, we saw a lot of aggressive underwriting, which created a lower-quality market. It's not that aggressive underwriting hasn't occurred over the past decade, but that we've seen this activity occur in adjacent markets. Those markets include the bank loan market and the private credit market, the latter of which is relatively new yet rapidly growing over the past decade. These are markets that typically provide alternative sources of financing for the types of aggressive deals that have previously been seen in the high-yield market.
Also, merger-and-acquisition activity has shifted to more strategic buyers in the post-GFC era, replacing private equity firms, which tend to employ a large amount of debt leverage when buying companies. This helps to partially explain the significant growth in the investment-grade market and lower levels of issuance in traditional high-yield corporate bonds. In a nutshell, these events have left us more comfortable with the potential returns of high-yield as we move into an upcoming period of expected recession.
How do your expectations for the 2023 performance of traditional high-yield bonds versus bank loans (or even private credit) differ?
Given some of the fundamental trends that we've seen across various noninvestment-grade markets—aggressive activity in the bank and private credit arenas, for example—we expect high-yield should hold up better, both fundamentally and from a performance perspective, relative to prior recessions. Corporate balance sheets in general are in decent shape, as is the composition of the broader high-yield market.
At the same time, we do expect that default rates will increase from current levels, if only because we've been sitting at record lows for quite some time. There's nowhere to go but up.
Not all high-yield corporate bond strategies are the same. What's your approach to investing in the asset class and what makes your approach unique or more effective? How has the current economic environment been challenging or fortuitous for your approach?
The high-yield team at Vanguard seeks to generate outperformance through three primary strategies: first, by having a structural higher-quality bias; second, through issuer diversification; and third, via our bottom-up security selection process. If you look at it empirically, this three-pronged approach is a time-tested way to potentially outperform over the long term.
In the fixed income space—the high-yield segment included—the ability to be up in quality is a real advantage. Fixed income risks are asymmetric, usually with much more downside than upside. So, our advantage is tied to our low fee structure, which allows us to be more patient and disciplined about selecting high-quality issues, particularly when spreads are tight relative to our competitors.
We have a collaborative, world-class team that we've built from the ground up, attracting high-caliber people from other world-class institutions and from within our own ranks here at Vanguard. We've grown from a team of four in 2017 to 13 team members today. The combination of our deeply knowledgeable team and collaborative process gives us the ability to be nimble and opportunistic, even during less-attractive market conditions.
Our team's diversity of experience helps with security selection but, when spreads are tight, you can't outperform with beta. Similarly, when dispersion is low, it doesn't matter if you have a strong team. In the current environment, when dispersion is high but spreads are tight, we're able to play to our strengths. We can practice patience and wait for better entry points but can also take advantage of our team's experience to identify the winners.
Finally, our portfolios are true-to-label. You know what you're getting. Our benchmark construction allows us to show investors which asset classes they will be invested in, most of the time.
It's also worth mentioning that Vanguard has invested a lot in building out its high-yield business. We're here for the long term. We see a lot of attractive opportunity for active managers within high-yield.
What steps do you take to assess whether investors will be adequately compensated for the added risks of investing in high-yield bonds?
First and foremost, everything we do, across all our actively managed funds, is bottom-up. We assess each issuer's fundamentals in terms of both quantitative—How much debt does a company have relative to its profitability? How much free cash flow does it generate?—and qualitative—What industry is the company in? Is it a cyclical or noncyclical industry? Who is the management team?—factors. We apply these assessment factors consistently across each of our investments. On top of that, we assess market valuations. Is the market compensating us for what we think the risks are? This is how we calibrate our portfolios to ensure we pick the best opportunities available.
How are you positioning your high-yield exposure considering the current market? Which types of bonds are you buying or avoiding? How large is your high-yield allocation across Vanguard portfolios relative to "normal" times?
Because of our cautious view on high-yield right now, we're taking a defensive stance with our positioning, favoring noncyclical sectors, and retaining a bias toward higher-quality issues. At the end of the day, selection is key, so everything we do comes from a company-level, bottom-up perspective. That said, we do consider the top-down overall macro backdrop. Because of current weaker economic conditions and tighter monetary policy, it makes sense to be more defensive and wait for better entry points ahead before taking on more risk.
Our high-yield allocations across portfolios are below average right now, which is reflective of the cautious view we have taken toward the segment. Our caution has less to do with concerns about fundamentals and more to do with current valuations that don't appropriately compensate us for the risk we'd be taking on. These higher valuations don't leave us much room to absorb any negative surprises, whether they come from weaker-than-expected economic conditions, an increasingly aggressive monetary policy, or geopolitical events.
What has surprised you about the high-yield market over the last year?
The biggest surprise—for both us and market participants in general—is how well high-yield has held up, despite an aggressive Federal Reserve and material weakening in the economic outlook. Normally, if you told people that a recession was coming and that the Fed would remain very aggressive, you'd see a lot more underperformance. In retrospect, one of the key reasons why the market held up so well has to do with a very supportive technical backdrop. Issuance in the high-yield market in 2022 was down 78% compared with 20211 and, at the same time, there wasn't a drastic uptick in outflows.
Why was issuance down? First, there was less merger-and-acquisition activity. Second, there was a significant decline in refinancing activity given the higher-rate environment, particularly as many companies had taken advantage of the longstanding low-rate environment to clean up balance sheets. They just didn't need to issue debt, and it wasn't attractive to do so.
The combination of these two anomalies helped buttress the high-yield market during the past year.
Finally, there's the upgrade story. A lot of firms received ratings upgrades to investment-grade in the past year, which excluded their issues from the high-yield segment of the market.
Attractive yields across many segments and our expectation of continued volatility create an environment for active fixed income to shine.
1 Source: JP Morgan
Note: This interview was edited for length and clarity.
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