FidelityConnects: The latest in global high-yield bonds

[00:03:27] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Richie. The global high yield bond space can be a good place to weather recession or actually sing along with a bit of a risk-on environment. With 10-year Treasury yields at elevated levels how is the picture looking for that extra piece of yield one can earn via the high yield bond market? Our next guest says it's looking pretty good, actually. With some investors moving away from U.S. assets do other hunting grounds, like Europe, maybe, become more interesting for high yield issuance? Joining us today to tour through spreads, dispersions and sectors of the high yield bond trade is fixed income portfolio manager, Peter Khan. Great to see you, Peter. Welcome.

[00:04:10] Peter Khan: Nice to see you, Pamela. Thanks for having me back.

[00:04:11] Pamela Ritchie: Delighted to have this time to have a conversation with you. We'll invite everyone to send their questions in over the next half hour or so. Can we begin with the story of inflation? There are a lot of headlines right now around the Fed. I guess it's really this question of a pendulum swinging to lower rates sooner. What's your read on inflation right now, Peter?

[00:04:36] Peter Khan: Inflation has definitely been falling over the course of the last year and a half in the U.S. but still remains uncomfortably above kind of the required target levels. The additional noise of the ongoing tariff negotiations with the delayed impact from the punt of the issue into the long grass over the course of the summertime from April to the now August 1st deadline, if that's truly a deadline but let's assume it is an actual sort of hard deadline for the tariff rates that are going to be implemented. Then as we get into the latter half of the year that's going to have a follow-on effect upon the headline level of inflation. The debate now amongst investors and the administration and the Fed is whether we should be looking through that because it's a one-off change in the price level, or whether it's something bigger, deeper and more problematic. Markets are on the fence, as you referred to, the 10-year Treasury rate remains kind of at the higher end of the trading range of the year-to-date so it's quite topical and still important to find out where some of these details get painted in on the actual sort of levels of tariff rates.

[00:05:50] Let's keep it all in context, the effective tariff rate in the U.S. has moved from 2 1/2% at the beginning of this year to now mid-teens. It's likely to remain. The one thing that I think we know is that the floor on that effective tariff rate is going to remain low to mid-teens for the foreseeable future, and could go a little bit higher depending upon further announcements and changes of views on the sectoral rate levels that are merely a function, seemingly, of one man's whim. Right now there's a lot of uncertainty at the moment and that limits the Fed's ability to cut rates even though they've now been given some headroom to make further adjustments.

[00:06:37] Pamela Ritchie: With that, tell us the story of how a little bit of inflation ... a little bit of inflation for equity markets is kind of good because there's some growth there. With high yield bonds having some, at least their movements often linked to risk-on moments within the markets or equities, is a little bit of inflation a little bit more than we have right now okay for high yield bonds?

[00:07:02] Peter Khan: Yeah, a little bit of inflation is not terrible for high yield bonds. Actually, even more inflation, more headline growth or nominal growth is great. The more leverage you have the more that gives you the ability to just continue at the same level of unit volumes year in and year out but actually kind of get away from your nominal debt stack thanks to inflation, assuming that it doesn't have a knock-on effect on demand for your product. Too much inflation is clearly bad because that generates a lot of uncertainty and diminishes confidence in the overall system. I think that we're sort of teetering towards the precipice of a confidence induced moment at some point in the U.S. over the next decade, according to Jamie Dimon, maybe less, and I'm not going to pretend to be any more clever than him, certainly probably a lot less. It could happen next year, it could happen sometime in the 2030s but on the basis of the current trajectory that's the kind of elephant in the room.

[00:08:09] Pamela Ritchie: That's fascinating. We've talked a little bit about a yearning for income. You've been at this particular area of the bond market for, I think, 20 years, mostly in England so you had a very global perspective, is that right?

[00:08:25] Peter Khan: Correct, yeah.

[00:08:25] Pamela Ritchie: You started there.

[00:08:27] Peter Khan: I started there with Fidelity in the year 2000 so--

[00:08:29] Pamela Ritchie: Okay, so there we go.

[00:08:30] Peter Khan: --heading for a silver anniversary.

[00:08:32] Pamela Ritchie: Well done, well done, congrats. There is an interesting moment yearning for income right now and I don't ... Canadians, for instance, have always liked income and dividend funds and so on, there seems to be something just a little bit more right now. Are you seeing that? You're the person who's watching this.

[00:08:47] Peter Khan: Yeah, without a doubt. That's been one of the key pillars of support for the high yield asset class and for credit markets generally over the course of the last year, is the fact that there's a very generous income level at a headline rate on offer in our asset class, particularly if you look back in context, maybe not in the last 25 years but in the last 15 years or so, particularly when we're in that low growth, low inflation ZIRP environment for so long.

[00:09:19] Pamela Ritchie: ZIRP, that's a good word. There was not much there.

[00:09:22] Peter Khan: There was not much there. At a headline level we're looking at above average income generation rates in high yield back to the financial crisis, and actually pretty close to the historical average all the way back to the dawn of high yield time, which is the mid-'90s. With inflation low and, hopefully, under control, somewhere in between 2% and 3%, and a high yield coupon rate at about 7% at the moment ... you have to factor in for various other risks, defaults and liquidity, et cetera, but in terms of a real income generation potential it's certainly an asset class with one and that's attracted a lot of interest from a combination of institutional wholesale and retail investors over the last year.

[00:10:11] Pamela Ritchie: Fascinating. Within that let's get into the discussion of sort of the U.S. exceptionalism, yes, no. There's the big beautiful bill, of course, that got through. There's probably lots in there that must be of interest to you. The depreciation piece must be kind of interesting when you're looking at balance sheets and you're looking at how companies are funding themselves. What did you like about that piece of policy, and then we'll go a bit global.

[00:10:34] Peter Khan: Well, in isolation, that piece of policy should promote a lot of capital formation and inward investment flow to any country that's going to implement it. Unfortunately, this one comes with strings attached so it hasn't been the sort of silver bullet to automatically generate a flurry of activity, even though we've had a lot of announcements around AI and data centres and whatnot. There's a lot of other structural reasons for that too. Some of those projects are clearly going to be benefiting from this new goodie that they've been provided by the reconciliation bill, so much the better for them. Other industries that might be buffeted by other forces, including tariffs and a general risk of trade negotiations, not to mention the fact that the level of uncertainty, I know that's often been talked about here on your show in the last couple of months, the uncertainty index remains kind of through the roof.

[00:11:36] The question is now, have we reached peak uncertainty? People will just decide to get on with their lives and start to make investments and plan for growth. Yes, they do and they have to but it's one thing between choosing to go buy this or that small item and another thing to build a multi-billion dollar factory in a foreign jurisdiction where the laws might all change in three years. It remains to be seen whether or not it will have a lasting material impact but in isolation it should.

[00:12:12] Pamela Ritchie: There's probably more there. I'm curious about the discussion of assets, U.S. assets being either less attractive or just investors moving new decisions elsewhere. There's some discussion that actually the European high yield market has had a little lift because funding companies that weren't necessarily able to go to debt markets suddenly can because money is moving out of U.S. assets or maybe [indecipherable]. Is that what you're seeing? These are narratives that fly around in the market, I don't know if they're true.

[00:12:42] Peter Khan: Based upon what we can observe within our own kind of global franchise is that marginal investor preference for European assets has increased since Liberation Day 1.0. Investors everywhere are hungry for yield and, again, positive real inflation-adjusted income. That's available in emerging markets assets. Most of those are denominated in dollars, though, so that's come with the additional headache of the currency volatility. Euro assets, the U.S. in many ways, what the administration's been doing in kind of negotiating with mainly sticks and not carrots is taking advantage of the fact that the dollar is the world's reserve currency. There's a lot of dollars around but people do have a choice to go to Europe if they can overcome some of the historical objections or concerns about the longevity and sustainability of the Eurozone as a block, which isn't at the top of anybody's list of worries right now but should always be on the long list. It doesn't take much with marginal capital flow into a smaller market like European high yield, which is about one-third of the size of U.S. high yield, to create sort of a savings glut effect and enable a lot more issuance and new names to come to the market because people are desperate to put money to work.

[00:14:23] Pamela Ritchie: Some of the changes in the U.S., the policy changes, has it led to, in certain sectors, I mean, health care might be one we talk about more, sort of fallen angels, companies that used to be very much investment grade but because the wind's been taken out of their sails through policy, this may be a question globally for countries that are battling their own budgetary issues and taking money out of something to go to defence so it may be sectors around the world, but is there a movement there that you're seeing fallen ages because of sectoral tariffs, basically, or changes to policy?

[00:15:01] Peter Khan: I wouldn't say that they'd be the primary driver of the fallen angels that we've seen so far this year but it certainly has been a factor and is likely to remain a factor that can push a number of companies closer to the precipice of coming down to the junk yard, so to speak. The couple of largest fallen angels this year in the U.S. would be Warner Bros. Media and Whirlpool, a couple of household names. Warner Bros. Media, we can put that aside in terms of the tariff impact, but Whirlpool certainly is a name that has been very topical in and around the tariff conversation in the first Trump administration.

[00:15:45] Pamela Ritchie: It was all about the Chinese made washing machines.

[00:15:47] Peter Khan: It was all about get those washing machines made somewhere else, and did the attempt to onshore and do this and do that have a material benefit for Whirlpool, it doesn't look that the evidence supports that. So here we are again. Is Whirlpool in the crosshairs of the discussion these days? No, not necessarily, but the impact of the policy implementation at the margin is not helpful for demand for their product. People don't buy new washing machines every day. When they do it tends to be a larger decision associated with household formation. The combination of fiscal policy and trade policy and its impact on the level of rates at the long end of the curve is, at the moment, not particularly helpful for the housing market.

[00:16:41] Pamela Ritchie: For the housing market. Interesting. Let's talk a little bit about Canada, and, again, we'll kind of swirl back to some of these things. How is Canada looking as a place to invest, really, for global investors? There's a domestic investor which probably has a different profile but I'm kind of curious how Canada is stacking up at this moment.

[00:17:01] Peter Khan: Canada is in an interesting spot for a number of different reasons.

[00:17:05] Pamela Ritchie: That's a good way to hedge your comments.

[00:17:08] Peter Khan: From a global high yield market perspective there are a few Canadian dollar issues that kind of pepper the investible universe but they're few and far between. The size, they tend to get tucked away to domestic investors. Historically, global investors have not had a huge menu of choices in thinking about Canadian issuers. For the most part, actually, Canadian issuers take advantage of the fact that they have, historically, very strong relationship with the U.S. and with U.S. investors. Good perception means strong capital market access, means when they want to raise a lot of money they've usually done it in U.S. dollars rather than in Canadian dollars. That'll be an interesting thing to observe over the next year or two, depending upon how things shake out, whether the domestic market starts to be someplace that attracts more intention from global investors but you need a bit more kind of bulking up in liquidity provision, I think, to really unlock a large flow.

[00:18:21] Pamela Ritchie: With the high yield market there are always competitors. Certainly, within the financial industry many of the private either  creditors or private equity stories are often going after investments in similar companies. How is that different now? Is it the same? Has it changed? Some people will say private equity has peaked a little bit recently. I don't know. What do you see?

[00:18:45] Peter Khan: On the credit side of business, private credit was the rage in 2023 and 2024. It slowed down a little bit but it still continues to steadily grow from what was a very low base to now is a more material base. The last great estimate that I saw on the relative size of the markets the U.S. leverage finance market, which is loans and bonds, is about $3 trillion. That's split 50/50 between loans and bonds. Private credit that's been accumulated and invested is somewhere around a trillion.

[00:19:19] Pamela Ritchie: You don't really know.

[00:19:20] Peter Khan: Well, you don't really know, number one, so the best estimate is it's around a trillion, plus or minus 200 billion, with maybe 800 billion deployed and another 400 sitting in dry powder available for investment in the market. That's slowed down a little bit. Why? Number one, activity in the public markets has picked up. Number two, there have been a few more issues on the default side, or restructuring side, in private credit than there have been in public credit and that's maybe given pause for thought or, more likely, just gives a bit of a negotiating leverage to investors to demand more return in private credit. If they can't necessarily get it then issuers can fairly easily at the moment pivot to public markets and just say, okay, the loan market is starved for product, or the bond market is starved for product. Investors have been accumulating a lot of cash because they're still very focused on generating income. People are learning how to use the markets interchangeably on both the issuer and investor side.

[00:20:36] Pamela Ritchie: So it's not necessarily an issue of some complacency with private markets, actually, it's, in a way, providing quite a lot of opportunities.

[00:20:43] Peter Khan: Well, I didn't necessarily say that. I'm naturally a bit of a pessimist and a cynic so I always need to correct myself.

[00:20:50] Pamela Ritchie: You're a bond trader so you have to be.

[00:20:53] Peter Khan: Exactly. The cynic would say that a lot of problems are being stored up in the private credit market, maybe put more politely, a lot of misallocation of capital is occurring in that space because there's been robust, almost exponential demand that typically, based upon historical experience, has led to watered down investor protections and less discrimination between business models or the ability of a business model to be sustainable in its current form. That happens in public markets and private markets. We can't say it's us versus them kind of thing.

[00:21:36] Pamela Ritchie: You can just see it a bit better.

[00:21:38] Peter Khan: You can see it a bit better. That's it, daylight, sunshine is the best disinfectant, people often say. The daylight and scrutiny in the public markets forces people to come to a reckoning. The private markets have the benefit of, basically, putting off the day of reckoning almost in perpetuity. You need to get compensated for that. You go into that eyes wide open, you understand, okay, this may not necessarily be everything that I expected it to work out as. As an investor you say, I therefore need an additional spread. The pitch from the producers of the product, which I think is a very effective one, is it's not a mark-to-market asset, you don't need to worry about it. You're not going to be able to get any liquidity out of it if you necessarily want it tomorrow. That's the trade-off. As a trader you always say, well, there's a price for everything so what's the right price between the two markets, that's going to ebb and flow over time.

[00:22:46] Pamela Ritchie: It's really interesting to get your thoughts on that particularly. There is no way of avoiding this. What impact, is the question coming in, Peter, would a change in the Federal Reserve chair have on the high yield space? You touched on it earlier. Let's just put that straight to you.

[00:23:01] Peter Khan: Very topical. The Mirror sort of 15, 20 minutes ago was getting a flurry of headlines about Mr. Powell's longevity, or lack thereof.

[00:23:12] Pamela Ritchie: You sort of thought maybe this wouldn't happen but now maybe it will.

[00:23:17] Peter Khan: You certainly hoped that he'd be allowed to serve out his tenor without an excessive amount of interference. The creation of a shadow Fed is something that the market could probably deal with and Mr. Powell himself seems to be thick-skinned and fairly capable of managing himself. That's probably something within the realm of possibilities that people have been thinking about. What nobody really wanted to see was an interruption of his term. If he's replaced for cause, there's no doubt to be a legal battle in and around that, but if he is replaced for cause then markets will quickly pivot to scrutinize who the successor is. That it's of extreme importance, I would say, to all markets that that individual, or set of individuals, who come into the new FOMC board are seen as sufficiently independent-minded and kind of based in, let's say, fact-based analysis as opposed to being under the thumb of the president.

[00:24:37] Pamela Ritchie: That will work its way out through the markets and the markets will analyze that.

[00:24:42] Peter Khan: It will. It should really manifest itself first and foremost in a combination of the dollar and Treasuries, the overall level of rates and the shape of the yield curve but, of course, all of that will have a significant effect upon the rest of the fixed income markets.

[00:24:58] Pamela Ritchie: Fascinating, just to put that straight to you. Let's go into some of the sectors themselves. We mentioned health care because the policy literally has probably changed the calculation for it but media and telecom was another area that you looked at. There's some old industries that I think must be mired in debt but how interesting are they to a high yield investor?

[00:25:19] Peter Khan: Oh, they're all extremely interesting to a high yield investor because they're moving in different directions at the moment. To come back to your point on fallen angels and where will policy drive more of those, health care could be a space where we see some of the managed care organizations that are seeing the rug pulled out from under them, depending upon how much concentration they have in their business lines to Medicaid and related program and tax credits. We've already seen some warnings and guidance pulled back from a number of the significant players in that industry. Their credit ratings are low triple-B and we expect that one, or maybe more of them, in 12 months' time will be back into high yield space, which from their perspective might not be great. From our perspective market growth is always good, particularly the ability to choose names that have large balance sheets, reasonable cash flows, many levers to pull in order to continue to shore up the balance sheet and live to fight another day.

[00:26:31] Pamela Ritchie: Presumably, there's great demand for all of their services. It's not like there isn't an ageing population, for instance, in the United States and Canada and everywhere else. There's an area that the business case is there but their model is shifting

[00:26:43] Peter Khan: Correct, correct. It's always going to be a defensive industry. It's likely to remain at the more expensive end of high yield but it gives us an opportunity to choose from a basket that should be a little bit further from the default event horizon than, let's say, a bog standard triple-C. On the flip side, you asked about telecom and media, that's space that we like. There are a lot of legacy businesses there that were kind of just being milked and left for dead. Think about your copper wire telephone provision which...

[00:27:22] Pamela Ritchie: Although copper's changed now too but in any case...

[00:27:24] Peter Khan: Yeah, copper's changed. Maybe the wire is more valuable than the voice business at the moment. That could be a problem in terms of additional costs in protecting it. The lifeline that a lot of those businesses have been thrown, and they've needed one desperately because a combination of declining revenues and increasing competition, the lifeline is anything and everything around fibre. I think we discussed this last time, had a little bit of fairy dust thrown on it. It took a little while for that stuff to sort of filter down to the high yield space but it really has transformed the prospects for a number of equipment and service providers in telecom technology and media, giving them a new lease on life. In our space that's all you need. If you can generate reasonable cash flows regardless of the level of growth, and you can service your debt and find an opportunity to enhance the value of your assets somehow by transforming them into something that's critical for a new business model that's developing then, hey, presto, you have another three to five years to play.

[00:28:40] Pamela Ritchie: You become like the Broadcom story, right? Suddenly it's relevant to an AI generated economy. This is what we're heading towards.

[00:28:50] Peter Khan: Correct, and that's also kind of even arrived in the utility sector. Utility is big, defensive, et cetera, but there are also some IPPs, independent power producers, that have been high yield issuers for an extended period of time. They trade at discount, they have higher cost of capital to your standard, well established residential utility, but they have enjoyed a lot of spread compression, so a reduction in their borrowing costs because they now have a new...

[00:29:23] Pamela Ritchie: Plug into a hyperscaler.

[00:29:24] Peter Khan: Exactly, they now have a new source of growth which is never a bad thing for any credit.

[00:29:31] Pamela Ritchie: That's fascinating. Within the sectors, that's a couple of legacy sectors, anything else? I want to ask, actually, about airlines as well. I mean, how are they looking? It's been a rough go for a few months from sort of their scrambling but it looks like there's a massive pipeline for almost every airline around the world. What, ultimately, does this space look like to you?

[00:29:55] Peter Khan: That's a great question, and I'm going to try to resist the urge to make as many dad jokes as I possibly can about turbulence and bumpy rides and this, that and the other.

[00:30:04] Pamela Ritchie: It is sort of, yeah, it's hard not to.

[00:30:07] Peter Khan: It's interesting because the airline exposure that we have in the high yield market is typically asset-backed or backed by some sort of SPV, special purpose vehicle, which contains, say, the loyalty program of the airline so it's administered in partnership with a financial institution. The structure there is sort of amortizing and helps bondholders get more comfortable with the risks that they're taking. They're not just buying an unsecured bond from a fly-by-night airline that might cease to operate next month. I'm buying something backed by planes or gates or slots or card loyalty programs. That doesn't mean we can absolve ourselves of having a view on what's happening in the industry, and quite a lot of opportunity for industry consolidation we think is out there, particularly here in North America, which might be a better play for equity investors but also has some implications for those high yield names that are out there in the market. If they get swallowed up by bigger, more established sort of network carriers, that's great. We have seen that actually happen in our space over the course of the last year when Alaska Airlines bought Hawaiian. Even the Biden administration...

[00:31:30] Pamela Ritchie: Different climate.

[00:31:30] Peter Khan: Different climate but even the Biden administration's FTC couldn't find a way to say no to that deal. Now, we've got a bigger question that you're asking is, basically, about demand. Domestic demand in the U.S. still seems to be ticking along okay. International demand, particularly from external inbound to the U. S., as we all know, has collapsed. I'd say it's unlikely to recover soon. I mean, eventually it'll recover at some point but just like people are considering alternatives for the dollar when they want to park their assets they're strongly considering alternatives to spending their hard-earned money on travel to the U.S.

[00:32:17] Pamela Ritchie: That is fascinating, these big trends and how they translate into, ultimately, what you're trading and how you're investing within the funds that you manage. How would you wrap this up a little bit with sort of the moment that it is for taking a look, a stronger look at the high yield market?

[00:32:34] Peter Khan: High yield doesn't look bad. The prospects into the second half of the year for the income generation, it's not as great as it was six months ago when the coupon rate was a little bit higher at around 8, we're now at around 7. Take six months of that 7% coupon and add in some volatility and some fluctuation, you're probably looking at a mid to high single-digits return sort of year for the asset class, knock wood, unless we have some unforeseen event that knocks us off track which is, of course, in these days, possible at any time. That's one thing to consider.

[00:33:11] Pamela Ritchie: But there's a trade for that.

[00:33:12] Peter Khan: There's a trade for that, and then you throw on top of that, if you're concerned about the dollar, you're concerned about interest rates, high yield has a very low duration profile. High yield has improved a lot as an asset class over the course of the last 5 to 10 to 15 years in terms of the credit quality mix which, translated into simple terms from a risk perspective, means a lower implied default probability. All those things together have meant that high yield has typically produced reasonable risk-adjusted returns outside of extreme economic situations over the last 10 to 20 years. It's done so again, so far this calendar year, it's had kind of a rip-roaring start relative to the menu of global assets.

[00:33:59] Pamela Ritchie: It's fascinating to have you take us sort of around the world into all of these different stories that we do hear narratives about and ultimately how they translate into investments for you. Peter Khan, thank you for joining us.

[00:34:09] Peter Khan: Pleasure.

[00:34:10] Pamela Ritchie: Great to see you. That's Peter Khan joining us here today. Coming up over the next few days, tomorrow, Kyle Weaver and Becky Baker, portfolio managers of Fidelity U.S. Growth Opportunities class. They'll be here joining us for an update on where they're finding compelling U.S. equity investments through the second half. The show will be presented with live French audio interpretations so do join us in either official language.

[00:34:33] On Friday of this week, on the heels of the big banks kicking off earnings season, they are coming fast and furious right now, we will be looking at the banking and financial sectors, as well as consumer health in North America in reaction to interest rates, global investment trends. We'll be speaking with Lee Sotos who is portfolio manager and senior analyst, as well Thomas Goldthorpe, equity research analyst.

[00:34:54] Monday we'll see Director of Global Macro, Jurrien Timmer, he'll be back to dive into the latest macro themes that probably should be on your radar but are definitely on his. We will start off the week, as always, with Jurrien Timmer. Thanks for joining us. Have a great day. I'm Pamela Ritchie.