High yield bond valuations have been on a rollercoaster ride. The lows of March, when investors shunned riskier assets for safer ones, saw valuations for conventional high yield bonds cheapen to historic lows.
But a restoration of investor appetite, thanks in large part to a fast response by the US Federal Reserve in providing liquidity and supporting the asset class, has seen valuations recover.
While some of the value has clearly disappeared from the broad high yield market, not all parts of the high yield universe have recovered to the same extent.
High yield floating rate notes (FRNs) are an example of a high yield asset class that has lagged the rally. They continue to offer compelling value; the yield-to-worst (YTW) for global high yield is currently around 6.3%, compared to a YTW of 7.2% for high yield FRNs. YTW is the lowest case yield for a bond held to maturity.
High yield FRNs have a lower beta than conventional high yield bonds. This means they tend to perform worse than the index in strong markets, but better in down markets.
They are more resilient during downturns because they have more exposure to senior-secured issues and lower spread duration.
But 2020 has turned this on its head as high yield FRNs suffered a similar fate to the conventional high yield market during March's sell-off, but have trailed the wider recovery.
This relative underperformance has been driven by a number of technical, rather than fundamental factors.
For instance, collateralised loan obligations (CLOs) provide much of the demand for high yield FRNs, but recently many of these vehicles have become forced sellers. This has depressed prices, with demand from CLOs yet to pick up.
Furthermore, the broad high yield market has benefited from significant inflows from ETFs over the past couple of months, especially from retail investors.
High yield FRNs have not benefited from this trend, as there are no sizeable ETFs covering this subset of the main market.
Finally, the Fed has been buying both individual high yield bonds and high yield ETFs to support liquidity, and this has boosted prices in the broad high yield space. As non-eligible bonds, high yield FRNs have not benefited from this technical driver.
These technical factors have created a dislocation between the two markets, with high yield FRNs trading at a yield spread more than 100 basis points wider than the main market. This discount is unwarranted, especially given the senior secured characteristics of the high yield FRN market.
Though we acknowledge high yield FRNs should include a liquidity premium given their non-inclusion in the Fed's bond buying programme, their current discount to the broad high yield market is excessive and offers attractive value.
There is a potential opportunity within high yield FRNs: while the timing of any recovery is unclear, renewed demand from CLOs and other institutional investors could act as a catalyst over the coming months.
James Tomlins is a fixed interest fund manager at M&G Investments