How to handle liquidity risk in a high yield portfolio

Published on 3 February 2023

As rates rise and credit comes under pressure, selecting the right fixed income assets is key to optimising returns while managing risk. However, the liquidity picture for high yield assets, which have lower credit ratings than investment grade bonds, is harder to handle. Liquidity is key to trading out of positions as well as acquiring assets.

Tom Hanson, head of European high yield at Aegon Asset Management, tells us how liquidity in these bonds has been performing in 2023, the risks that liquidity management can create in the investment process, and the value of traders, as part of the investment process to support high yield investment.

Transcript of interview:

Dan Barnes: Welcome to Trader TV – your insight into institutional trading. I am Dan Barnes.

High yield markets offer great returns for investors, but also create challenges around managing liquidity. To discuss these dynamics today is Tom Hanson, head of European High Yield at Aegon Asset Management.

Tom, welcome to the show.

Tom Hanson: Hi Dan, thanks for having me.

Dan Barnes: Starting with this, how challenging is liquidity in European high yields currently?

Tom Hanson: I think the first thing to note is liquidity has always been challenged in the high yield markets, but I don’t think there’s any particular problem right now. European high yield markets have grown significantly over recent years. It’s probably about 40% bigger now than it was pre-pandemic. That certainly helps improve matters.

I think one thing that has potentially challenged some of our liquidity is the primary market has seen a sharp drop off last year with very, very low by historical standards. A sort of busy primary market leads to a busy secondary one. So that’s certainly something that perhaps has acted as a headwind. In terms of liquidity in the names we invest in that is of paramount importance to us as investors given that we provide daily liquidity on our funds. So we’re very careful there. But really it’s when the market becomes super stressed that you notice that liquidity drop off. Again COVID would probably be the great example of that. But at this point in time, we’re not really seeing any operational challenges whatsoever.

Dan Barnes: How does that compare to investment grade markets, which investors might be more familiar with?

Tom Hanson: Yeah, well, it is a less liquid market overall, given that it’s much smaller. It’s about a fifth or sixth of the size of European investment grade. The market has grown and become much more mature in recent years. I think the double B part of European high yields, so that’s the greatest part of it, about 70%, in general that’s the most liquid part and that’s probably where that’s the greatest crossover with the investment grade market, because there’s a lot of investment grade market participants have played in high yield over recent years. The lines have become a little bit blurred, but for sure the liquidity versus IG is more challenged in the lower rates. It’s certainly more cyclical names in our market.

Dan Barnes: So what is the value of overcoming the liquidity challenges in this market for investors?

Tom Hanson: High yield offers some great opportunities. Big spreads pick up versus investment grade, narrowing high yields after many, many years, we’ll joke about it. It should be called low yield to say a yields the worst of the global high yield market. You’re seeing decent spreads. Both of these things have been noticeably absent from the market in recent years. So the opportunities that are in our market now, we would contend is much more attractive.

Dan Barnes: And on that point, what are the macro factors that are impacting high yield markets at the moment, both in terms of returns and potential risks?

Tom Hanson: Well, clearly central banks and what they’ve been up to is the number one now. For years and years now we’ve had central banks providing an effective tailwinds to markets, but in doing so, they have depressed the risk free rate. They have compressed spreads and yields as they reverse. Now the opposite becomes true. And actually that’s the number one thing the market has had to get used to, is having central banks not in your corners that much anymore and in fact going the other way.

Now that definitely provides a headwind, but it also provides opportunity, higher yields, better spreads. Today, the market is not pricing in a recession at this point in time, but it is still providing an attractive entry point in terms of valuations. So it’s a case of how comfortable you can get with that as an underlying investor, but from our perspective, we think the market offers an attractive opportunity.

Dan Barnes: So finally, how does your team of portfolio managers and traders manage these dynamics to maximize the returns for investors but minimize the costs and risks they face?

Tom Hanson: I mean, it’s really all about trying to capture the best we can in the global opportunity set. So we tend to filter the global high yield universe through the way we in particular manage our funds. But should these ideas be eligible, it’s important for us to look in all markets, so notably, US high yield is the biggest component, it’s a global high yield about 60%, but European high yield falls about 20%, but you’ve got that rest of world component. So notably the EM high yield, which we invest in too, so all hard currency.

We’ve got a fantastic team of analysts across the globe, we’ve got 14 global high yield analysts, we’ve got a great number of global IG analysts. You know, for us it’s about picking those best bottom up ideas and almost leaving no stone left unturned in the search for value across the globe. And then combining them with a disciplined, top down framework to manage risk, manage beta through a cycle, to manage your ratings allocations and manage your sector allocations and to manage your regional allocations notably in terms of being able to deliver performance consistently.

Dan Barnes: That’s fantastic. Tom, thank you so much.

Tom Hanson: Pleasure.

Dan Barnes: I’d like to thank Tom for his insights today, and of course, you for watching. To catch up on our other shows or to subscribe to our newsletter go to TRADERTV.NET.