PGIM high yield manager Jonathan Butler warns of over-exuberance

Amid near euphoric moves in markets this year, yields on sub-investment grade companies have been compressed to the point where a sell-off is now likely.

After a sharp rise in interest rates since 2022 fixed income yields are relatively attractive.

But amid near euphoric moves in markets this year, yields on sub-investment grade companies have been compressed to the point where a sell-off is now likely, according to Jonathan Butler.

“In the very near term, we think the credit spreads – the margin that a company pays over base rates – have got quite tight, and so that’s a bit of a concern for us, and we think there’s a there’s a lot of tail risks out there that we feel the market has been a little bit over- exuberant,” he said.

“Commercial real estate is fairly stressed, so that’s an area that’s underperforming.

“But if you look at the high yield market, credit spreads in the low three hundreds (basis points) – that’s at the tight end of the range for the last 15 years for where spreads have been.”

Butler heads European leveraged finance for PGIM Fixed Income and also co-heads the global high yield strategy for the global asset manager formerly known as Prudential Investment Management.

PGIM has about $US1.3 trillion ($1.99 trillion) of assets under management.

This year has seen shifting signals from the Federal Reserve in terms of the timing and scale of rate cuts investors can expect in coming years, though the market remains confident that rates will fall substantially.

A crucial update on the Fed’s preferred inflation measure – the core PCE deflator – will come on Friday.

If interest rates fall as expected, it should lead to capital gains for bonds in general.

But PGIM’s house view is that markets have moved into a period where rates will be higher for longer than expected, even as it expects rates to start falling this year – as the consensus expects.

Like many investors, PGIM worries that inflation could remain “sticky” versus central bank targets.

“Obviously headline inflation has come down a lot and core inflation has fallen, but it’s still around 4 per cent, and if you look at what’s happening in the world in terms of less globalisation, that’s inflationary,” Butler says.

“At the same time, commodity demand related to decarbonisation is increasing and there are geopolitical risks that could increase the need for militarisation, which may be inflationary.”

Outside of commercial real estate, the health of the corporate sector has been much better than feared, although Butler is still wary of the fallout from aggressive interest rates in the past two years.

He uses scenario analysis rather than basing his decision purely on economic forecasts.

“We are getting to a point where the Fed and the ECB feel they have tightened enough to tame inflation so they can start to ease, but we don’t know whether they’re hiked too far and will cause negative growth, but obviously raising rates creates pain for the more levered businesses,” he says. “So that pain really only starts to take effect 12 to 18 months after rate rises, so we’re still in that period of seeing how much pain there is.”

Alongside that risk of pain for highly indebted borrowers is the risk of inflation remaining stubbornly high for the reasons mentioned above, something that younger generations haven’t experienced.

“We had 30 years of globalisation, so what we’re saying is that the globalising political elite are going to get changed by a more nationalist outlook from different governments,” Butler says.

“You see that in European governments, you’re obviously seeing that with the likes of Donald Trump, and so let’s see what that brings.”

Obviously if recession hits, inflation will be less of a problem, but on the current economic growth outlook, inflation could spend more time above central bank targets in coming years.

The one industry that is struggling is real estate, particularly in Europe, and PGIM is underweight commercial real estate. In many cases fixed rental incomes and an increased cost of debt has hit profitability.

At the same time many have faced significant capex to meet environmental standards.

So far the corporate pain has only been obvious in commercial real estate and businesses that leveraged up aggressively when interest rates hit historic lows during the pandemic, but the outlook depends on the outlook for the equity market as well as interest rates.

“If you’re a business where, of your enterprise value, 20 per cent is debt and 80 per cent is equity, you can cope with quite a considerable increase in interest rates,” Butler explained.

“If you’re running with 80 per cent debt and 20 per cent equity, then clearly your free cash flows are going to get hit pretty severely with rising interest rates.”

He notes that in 2021, before the rate rises, the cost of debt for risky borrowers was about 4-5 per cent. With interest rates rising and credit stress it’s now costing them 9-10 per cent.

“It creates credit stress and some companies have more resilient balance sheets than others, but outside real estate, there’s not one industry sector that really sort of gets whacked,” he says

Butler manages strategies relative to the ICE BofA Developed Markets High Yield Constrained Index through “bottom up” security selection.

While commercial real estate is the one sector he’s avoiding, there are other companies which he feels have too much debt, and their bonds are trading too “tight” and are likely to be sold.

Looking past the expected US rate cuts this year, a further test of corporate resilience could come if interest rates don’t fall as much as expected amid stronger growth.

“We’re either in this higher-for-longer interest rate outlook, in which case bond coupons stay high and fixed income investors do well, or the market is right and interest rates come down, in which case you then get the capital gains in the near term, and then obviously, lower yields,” Butler says.

But in the near term he notes there are fears about rising default rates. “I think the markets have come a long way … 2023 was a really strong year for fixed income, and high yield and returns were very strong … year to date, markets have rallied.

“We can we can certainly imagine that the economy is likely to see some of these shocks and the entry point to get into the market may be at some point soon.

“Obviously, we’ve seen plenty of volatility over the last 15 years, and we’re trading at the tight end of the range, spread wise, so we can easily see that widen out.”