Artemis Funds (Lux) – Global High Yield Bond update

Review of the quarter to 30 September.

The fund made 1.3% over the past three months, outperforming its ICE BofA Merrill Lynch Global High Yield Constrained USD Hedged index, which rose 0.9%. While the fund is 1.3 percentage points behind the index year to date – driven largely by our loss on Credit Suisse in the first quarter – we are comfortably ahead over three years and since inception.

In the third quarter, yields on the high-yield market rose by 20bps, from 8.69% to 8.89%. This move was entirely driven by the movement in government bond yields – credit spreads actually tightened over the period, moving from 467bps to 448bps. The most significant driver of fixed income markets over the period was a delay in the market's pricing of rate cuts. This saw the yield curve steepen, as longer-dated bonds underperformed shorter-dated ones. Our focus on relatively short-dated high yield, which is itself a reasonably short-maturity universe, aided performance over the period.

Risers and fallers

The largest positive contributor to performance in the quarter was a position in German electronics company ams Osram, which announced a capital-raise to deleverage and upgraded its earnings outlook.

The ams Osram story illustrates some of the positive trends that have got us excited about the prospects for global high yield. First, the proactive way in which issuers are addressing so-called ‘maturity walls’: they do not want to be hostage to market conditions at the last moment, so will trade a higher coupon and early call at par of their bonds for certainty of execution.

This demonstrates the hidden return of high yield which is not captured in published yield and spread numbers. Given the average bond in the global high-yield index is trading at a price of 86c in the dollar/euro/pound, almost all yield figures assume that bonds will be outstanding until maturity as this represents the so-called ‘yield to worst’, or the lowest possible yield out of a range of possible outcomes. It is normal to use this figure as it is the most conservative yield expectation. However, when companies prematurely repay at par, it significantly increases the return.

Second, it underlines how nervous the market is. ams Osram is a high-quality company that encountered market headwinds and other issues while expanding capacity. At its recent nadir in July, its US dollar bonds were yielding more than 16%. While these are common in the history of the high-yield market, in this case they came about as leverage (net debt to EBITDA) was less than 3x on a revenue base of more than €4 billion. The time to worry about high-yield excess may come at some point in the future, but not while we see opportunities like this.

Elsewhere, bonds in Standard Profil (a German auto-parts supplier) and Ocado (a British grocery technology firm) aided performance, while longer-duration bonds and positions in ZipRecruiter (a US recruitment website), At Home (a US home furnishings retailer) and Heimstaden (a Scandinavian residential landlord) detracted from it.

Activity

The fund was reasonably active over the quarter, as we bought bonds of relatively short maturity that we thought could deliver attractive income with the added kicker of a potential near-term refinancing. Their lower duration means they are also less exposed to moves in government bond markets and spread widening.

Names in this category include Concrete Pumping (a US-based renter of concrete pumping trucks to construction companies), Paprec (a French recycling company), Techem (a German energy metering business) and Williams Scotsman (a US-based provider of modular buildings such as portable cabins).

Following strong performance, we took profits in German real estate company Aroundtown, North American homebuilder Brookfield Residential Properties, US building products distributor White Cap, UK automotive fluid supplier TI Fluid Systems and North Sea oil & gas producer EnQuest.

We sold our position in the US-based MI Windows and Doors given the potential for the takeover of a rival (which would likely lead to more debt being added to the balance sheet). We also offloaded our holding in Albertsons, the US grocery chain, as a result of the bond market pricing (to our eyes) a slightly higher chance of the anticipated merger with Kroger occurring than we felt was justified.

Outlook

Government bond markets continue to bear the brunt of market angst. Markets are re-assessing the implications of a higher-for-longer environment and, while we believe we are near the end of this process, such trends have a lagged impact, which underlines the importance of an active approach.

We also have some misgivings about the way in which a ‘soft landing’ now seems to be taken for granted and do not feel it is the time to take undue risk. As a result, we remain light CCC bonds (further reducing exposure in September) and have no exposure to emerging market issuers.

At the same time, the negative sentiment gives us reason for increased optimism as we feel that markets will move on long before the consequences of tightening conditions are felt in the real economy. In addition, rates may be near their peak and in conjunction with moderating labour and inflation data, we believe the seeds have been sown for better conditions.

The risk/reward trade-off

In this asset class, where yields are close to 9% and duration exposure is relatively low, being too cautious entails a large opportunity cost and to us, the narrowing set of likely outcomes (good and bad) means positioning for an extreme risk-off environment looks overly cautious and expensive. Our approach will continue to add higher-quality exposure where we are being well compensated for any risk we take. Broadly, the names we are trying hardest to avoid are over-levered businesses that will struggle with the combined impact of higher funding costs and softening demand.

We retain exposure to carefully selected cyclical businesses and fundamentally believe they represent an outstanding risk/reward trade-off in the current environment. Given the uncertainty around the path of inflation, we feel that reasonably short-maturity BB and B credit exposure with just over three years of duration remains a very attractive part of the investment universe.

Investors have been given an opportunity to re-engage with fixed income at meaningfully more attractive valuations over the past two years – we believe that this year has demonstrated how