In an investment landscape that is increasingly being upended by technological progress and business-model disruptions, actively allocating to companies and sectors which are more resilient to disruptive influences will become more important to risk-balanced portfolio construction, argues Fraser Lundie, Co-Head of Credit, Hermes Investment Management, in his latest report, The path of least disruption: responding to technological change in high-yield credit.
The impact of technological disruption on equity and high-yield bond indices
The correlation between movements in stock-market returns and high-yield bond returns is an important input for portfolio asset allocation decisions. Historically, there has been a dependable correlation between equities and high-yield bond markets, but this has changed in the last decade: since 2008, the relationship between the two asset classes has become less correlated. Indeed, the downward trending correlation between the S&P 500 and the Global High Yield Index has been particularly pronounced in the last two years, reflecting the narrow leadership of the US stock market, which has been dominated by technology disrupters, most notably the FAANGs – Facebook, Amazon, Apple, Netflix, and Google, now Alphabet.
Whereas the weighting of the tech sector within the MSCI World Index has almost doubled over the last ten years (now standing at 14%), reflecting the influence of technology disrupters, the composition of the Global High Yield Index has experienced little change over this period. Its exposure to the technology and electronics sector today (just under 4% of the index) is broadly unchanged compared to 2008, when it represented 4.18%. However, this statistic does not reflect the extent to which sectors within the Global High Yield Index have been affected by technological innovation and business disruption models.
Locating a disruption resilience premium
Technological innovation has had a transformative effect on certain sectors - one such example being autos. There are the two main technological threats to traditional automotive manufacturers: electric vehicles (EVs) and autonomous cars. Today, nearly every major car manufacturer is committing to EV investments.
Ford had lagged behind its peers for some time despite the emergence of disruptive technologies, until the appointment of Jim Hackett as CEO in 2017. Since then the company has made a number of significant announcements about EV investments and initiatives and has pursued partnerships with other manufacturers, such as signing a memorandum of understanding with Volkswagen, to improve competitiveness. Today, Ford CDS, which has previously underperformed the US Investment-Grade Auto Index, is trading above 200 basis points – that’s more in-line with BB credit issuers. This shows that by allocating to an active global high-yield manager rather than investing passively, investors can navigate the threats and opportunities that disruption poses, such as those faced by Ford and General Motors, and identify outperforming securities.
Other sectors are less vulnerable to industry disruption and active global high-yield managers can choose to allocate to these sectors. Homebuilders – and the construction sector at large – have stubbornly resisted disruption, employing techniques and materials that are rooted in decades of tradition. Importantly, there are a number of fundamental hurdles that the industry would need to overcome to transform itself, which makes wide-sweeping disruption unlikely in the homebuilding sector.
Building codes and regulations, which specify the minimum standards for the construction of buildings and are generally country-specific, must be adhered to by companies operating in the sector. They would also apply to any industry innovations, which poses a challenge to technological disruption. Moreover, to innovate, companies would incur large upfront costs to invest in meaningful automation. In a low margin industry, there have been limited incentives to invest heavily in new technologies sector-wide, so far. In addition, new custom-built homes add a further challenge. We believe that any technological advances in the industry will be small, such as remote site monitoring, limited robotics automation to help builders dealing with a tight labour supply and smart homes or materials, which could be used by existing players in the sector.
We therefore believe that there should be a premium attached to sectors, such as homebuilders, that are less exposed to such structural change.
Capturing value from disruption
A trend is emerging in the high-yield bond market: in recent years, sectors that are less susceptible to disruption have been trading at a premium to disrupted sectors. This has become particularly pronounced in the past 24 months – the period during which the correlation between stock market returns and high-yield bond returns fell sharply. For example, in October, homebuilders were trading at a premium of 1.09x compared to the technology sector and 0.91x to the healthcare sector. This reflects the significance of allocating to an active global high-yield manager rather than passively investing, as they can navigate an investment landscape upended by rapid technology innovation – and importantly, select credit issuers that are benefiting from disruption or immune to it.
As technology-backed companies continue to disrupt market leaders and legacy industries, the technology sector will continue to represent a large proportion of equity indices. In turn, we expect that the correlation between equity returns and high-yield bond returns will continue to decrease, providing value from an allocator’s perspective: with some sectors less susceptible to disruption than others, it is becoming increasingly important to actively allocate high-yield bonds to a diversified portfolio. Moreover, rather than investing passively, allocating to an active global high-yield manager is also essential to navigate the risks and opportunities posed by disruption. That way, investors can control their exposure to both disruptors and the disrupted.
The above is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instrument. The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.