Artemis Funds (Lux) – Short-Dated Global High Yield Bond update

Review of the quarter to 30 September.

The Fund made 2.3% over the quarter, compared with 1.3% from its Secured Overnight Financing Rate (SOFR) benchmark. We were pleased to deliver this positive return in an environment where underlying yields moved higher: 1-5yr BB-B global high-yield bond yields rose from 8.0% to 8.2% over the period. It is worth noting that credit spreads barely changed over this time, rising from 371bps to 372bps.

Markets look likely to oscillate between fears that growth and inflation are unstoppable forces of nature on one hand and, on the other, that too much tightening by central banks has condemned the global economy to purgatory. There is plenty in recent data to confirm the views of bulls and bears alike, so staying nimble will be the key to navigating this difficult environment.

Why we're excited

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.

Risers and fallers

Elsewhere, our recent (re)investment in US sports entertainment operator Legends Hospitality was well timed and added to returns, as did positions in German auto-parts supplier Standard Profil, North Sea oil & gas producer Ithaca Energy and British grocery technology firm Ocado. We took profits from the latter three bonds.

Positions in Scandinavian residential landlord Heimstaden, UK process engineer IM Group and German wood products manufacturer Pfleiderer detracted from performance.

Activity

Following strong results from premium UK gym operator David Lloyd, we switched from its floating-rate notes into its 2027 fixed-rate securities at a sterling yield of more than 9%. Its latest numbers show evidence of strong pricing power driven by its investment strategy to ‘premiumise’ its service. By switching into the fixed notes, we added more upside optionality from its call-constrained floating notes.

Elsewhere, we lengthened our exposure in global drug-delivery device manufacturer Catalent. We rolled our exposure from its higher cash-price 2027 US dollar notes into its euro-denominated 2028 bonds. Again, we have both enhanced yield and increased upside in a company we believe has turned a corner following Covid-related disruptions in the past year or so.

We altered the fund's exposure in the property and construction sectors, selling positions in Brookfield Residential Property (US residential construction), Aroundtown (German residential and commercial property), and Alta Group (US equipment rental).

Additions included global doormaker Masonite International, as well as the largest concrete-pumping service provider in the US, Brundage-Bone. Both Masonite and Brundage-Bone have leading market positions and good exposure to non-residential construction activities in the US. We also increased our exposure to Williams Scotsman, the leading provider of modular buildings, such as portable cabins, in North America.

There were a few exits, including in US mainframe software provider BMC and French equipment rental provider Loxam. In both cases the bonds had rallied to a point of little additional return potential. In a target-rich environment such as the present, we rotated our clients' capital to where it could ‘work harder’.

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 have very little in CCC bonds (further reducing exposure to just 1% 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 over 8% and duration exposure is very 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 strongly that high-quality short-dated credit exposure with just two years of duration remains a uniquely attractive part of the investment universe.