Hello, and welcome back to Unlocking Markets, the RBC podcast, where we bring you experts from across our firm, providing opinions on markets, global policy, sustainability, and macroeconomics, whilst highlighting how these feed into our investment decisions. I'm Mike Reed, head of Global Financial Institutions. Today I'm delighted to welcome Sid Chhabra, head of European High Yield, Securitized Credit and CLO Management here at RBC.

High yield bonds are often viewed with caution by some investors, but have often generated returns that are greater than those from government or investment grade bonds. It will be interesting to hear from Sid, how he and his team navigate the asset class and generate returns for clients. Sid, welcome to the podcast.

Hi, Mike. Pleasure to be on.

Great to have you. Let's dive in. With core global interest rates having risen from their near-zero levels during the 2010s and Covid era, investors are now able to get much higher coupon rates than back then. Given this, what advantages do high yield bonds or high yield funds bring to investors?

Yes. If you think about the high yield asset class over the last 5, 10, 15 years, it's consistently delivered 300-400 basis points of excess returns over government bonds. It's not just in relation to government bonds; even compared to corporate investment grade bonds, high yield has delivered 300 basis points or thereabouts of excess returns over the last 3, 5, 7 years.

Today, with higher expected rates and a broadly positive backdrop for growth, and also with defaults on the lower end, I continue to see a favourable environment for the asset class to generate strong returns for investors over the next few years. One key point to note is that the asset class has also benefited from a continued improvement in quality over the last decade, because a number of companies within the index are at lower leverage points, which is also reflected in the rating mix, with a growing proportion of these issuers being double B rated.

All in all, it's an interesting and a favourable environment for the high yield asset class on a go-forward basis.

It's interesting to hear how the returns have been so good over such a long period of time. A lot of the investors we speak to are often very focused over a relatively shorter period of time, and your funds have delivered strong returns over the last 12 months. Given the maybe slightly uncertain current economic backdrop, do you believe they remain attractive here and now today?

Yes, Mike, very much so, actually. One of the arguments that, of course, investors will mention, is that spreads and valuations have tightened, and they have, but as we touched on earlier, with the benefit of higher base rate and generally, a backdrop of positive growth, we expect to see high single digit returns over the next 12 months. Very attractive, even though it's a little lower than the previous 12 months in this environment. High single digit type of returns, we think, are very compelling.

There are a few reasons for that, in terms of how we are able to see that return profile develop. If you think about the supply picture, M&A and LBO volumes are likely to pick up over the next 12 months. We see that as a channel from which we will likely see more supply relative to what we've seen in the last couple of years. Alongside that, there are a number of high yield issuers that still need to refinance their debt. All in all, we expect the supply picture to be healthy over the next 12 months, but that's not it.

There's also quite a bit of dispersion between single names in terms of where they're trading, but also within sectors, which, for investors like us, which are active, fundamental, bottom-up credit investors, that provides a very healthy ground for credit alpha generation. This is, as I mentioned, on a backdrop of good growth, stable growth, which means that defaults are not particularly high.

In fact, we expect base case defaults to be closer to 2 to 2.5%, many of them coming from well-known idiosyncratic stories. If I put it all together, 2025 is going to be busy for us from a supply side, from a dispersion side, but the carry of the asset class, with high base rates and spreads in the 300-350 basis points range, means that we think it's a potential for a high single digit type of return over the next 12 months.

That sounds very interesting, very attractive. I'm going to come back to that point you raised about the dispersion between sectors. Something also you mentioned was you talked about LBOs. I know that with your background, you have a very deep knowledge of leveraged loans. I'd be interested to hear your thoughts on how private credit interacts with the high yield market, and how this has developed, and how this helps your investment process overall.

Yes, it's a very interesting question, and very topical as well. Firstly, what I would suggest is that the development and growth of the private credit asset class is obviously a positive for corporate issuers, because it gives them an additional channel to source financing and credit. Rather than simply relying on the public channel of, say, high yield bonds or syndicated loans, there is this other channel that is developed and grown.

Secondly, private credit tends to offer solutions that typically give the sponsors financing at higher leverage points, many times at six turns or greater leverage versus the high yield market that is, on average, hovering around three turns of leverage. The positive dynamic for the high yield market comes from the growth of private credit asset class and loans, because what's tended to happen is that smaller issuers and mid-scale issuers, owned by PE sponsors, have had this other channel to get credit and financing.

They've gravitated towards private credit, which has allowed them, also, to get financing with higher leverage, leaving behind the high yield asset class, which, as I mentioned, is hovering at lower leverage, call it two and a half to three and a half turns, also therefore a higher quality asset class within the broader leveraged finance space. As I mentioned previously, the majority of the index is double B rated, and so, the development and growth of private credit has actually been a positive technical for high yield.

That's very interesting. I'm not sure investors are very aware of how the market has developed and this movement, as you said, of the improvement in the credit rating of the index overall has been now double B, and I think that's very important in how investors look at it, going forward, in terms of its risk profile.

Now, one thing I said earlier, I was going to come back to, which you touched on with the dispersion across sectors; and so, if you look across the markets today, which sectors do you feel offer particularly good opportunities, in your view and your team’s view, and obviously, which areas are causing you concern?

Yes. There are a few sectors that we like. We like these sectors for different reasons. For example, banks. Banks continue to report good earnings, strong earnings, and that's translating into improved profitability metrics. We like that sector. On a spread and carry basis, that sector is still trading wide, so we see good opportunities within that sector, and we are investing quite actively within banks and financial services.

A different sector that tends to be cyclical, like the energy sector, actually is also providing options for total return, particularly from the new issue market, because there's a lot of refinancing as well as corporate actions which are taking place within that sector. Although being a cyclical sector, it is providing compelling single name return opportunities that help provide alpha within our funds.

Telecoms sector, again, a well-known sector, but one that we continue to like, is a sector where there are a few single name issues. By and large, it's a sector that benefits from generally stable revenues that are growing. Within that sector, we have generally focused on those names which have an asset-rich base of infrastructure underlyings. We have taken picks within that sector, where there is an angle beyond just the earning profile.

I would say another sector that has had challenges over the last two years that, for us, this year, has been an active hunting ground, has been the real estate sector, and their issuers have had to grapple with higher rates, and previously, financing that was extended at stretched valuations. There's been more stress in the sector over the last 12-24 months, but this year, on the back of lower rates, particularly in Europe, there's been more compelling and interesting opportunities for us to capture value. We have been active in that sector as well.

A sector that we are cautious on, and we actually expect stress to develop a bit further, is European autos. We have been expecting lower profitability coming from China for a large number of the European OEMs, but also on the back of lower EV sales. We're starting to see this in earnings. In fact, in the last couple of months, I'm sure many have heard about the weakness, margins, and profitability of the European auto OEMs, as well as suppliers.

We don't think this is the end. We expect to remain cautious with, also, potential tariff newsflow picking up as well. We think this will translate to a bit more pressure on margins. Overall, if there was a sector that I would say that we remain somewhat cautious, it is on the European auto side.

Thank you. That's very helpful and also helps me because it gives me a lead into my next question. There's a lot of debate of passive versus active. Here at RBC, we run active investment strategies very successfully over the years. I'd be interested to know a bit further, a bit more meat on the bones, how does your team actually add value to investors?

Yes. RBC has been investing in the high yield market now for over 20 years. We have a large and very experienced global team. We have something like 20 analysts and over 10 portfolio managers. Actually, many of our analysts and PMs have 15, 20, 25 years of experience. What that means is that many of the issuers within the leveraged finance market, within the high yield market, we have followed their earnings, their performance, through many cycles.

That gives us, in our view, an edge, because our team knows these names really well, knows the issuers really well, have understood the dynamics of these issuers extremely well. Alongside that, if you look at our platform today, we have nearly 20 billion in assets that we manage within the leveraged finance cohort across global funds, loan funds, different types of vehicles, benchmark vehicles, as well as total return vehicles.

Because of the pace of AUM that we have, we're also very much a key counterparty to sponsors and dealers. When you combine that platform that we have, the size of the team that we have, the experience in the team that we have, and our connectivity with market, including dealers and sponsors, it does give us an edge in the way we express credit views in portfolio construction. That ultimately leads to better longer-term performance.

Our value comes, I think, to our investors who allocate with us, because we have a strong base. We have a strong team. We have a global team. We have an experienced team. We have, in my view, a very thoughtful investment process that's been time-tested. It's quite robust. If you put those elements together, ultimately, that leads to strong performance. I think we have generally delivered that over the last 5-10 years.

Well, that's very clear. I think investors will see that your team, over the years, has created value for investors and that your active style has definitely outperformed a passive one. Thank you, Sid. It was really great to get your perspective on the high yield market and the current opportunities, and also how you and your team work to generate alpha for investors in our funds.

Well, thank you, Mike. Thanks for having me.

It's been great having you on. Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. The podcast will be back soon, with more insights from the portfolio managers at RBC, which we hope will help you navigate the investment landscape across both equities and fixed income. Thank you, once again, for joining us today. Good luck, and goodbye.