High Yield: Reasons for Cautious Optimism
26 JUL, 2023
By Barings
A More Resilient Picture
To start, the long-anticipated worst-case scenarios triggered by the U.S. Federal Reserve’s (Fed) steady hiking of interest rates—recession, higher unemployment, sharply lower earnings, greater defaults—did not materialize over the past few months. Instead, a mixed but relatively positive picture has emerged. Earnings are on the whole somewhat lower, but services and leisure-related areas have held up well, as have companies benefitting from infrastructure spending. Softness in chemicals and other cyclical industries seemed in part due to customers waiting for lower commodity costs to filter down into prices. Meanwhile, despite some notable workforce cutbacks, labor shortages continue in many industries, keeping the unemployment rate low and consumer spending steady.
With the macroeconomic backdrop more constructive than feared, lower-quality credit continued to outperform. In fact, a ‘fear of missing out’ among those who had steered clear of risk assets may have contributed to the persistence and strength of the rally. Underlying the market’s resilience has been the strong financial condition of most issuers, which on average have lower leverage and higher interest coverage than they did before the pandemic. The credit quality of the high yield market remains at historically high levels with BB and single-B issuers making up 52% and 39% of developed markets high yield today, respectively, while CCC and below issuers comprise 9%1.
Default rates, although inching up due to some idiosyncratic cases, are expected to be around 3%2. Even if a recession arrives later this year or in 2024, a sharp increase in defaults looks less likely, especially given the ample cash cushions and financial discipline evident at many issuers. Moreover, at current and anticipated default rates, likely credit losses can be readily absorbed by the high yield market as high yield spreads are currently compensating investors for defaults more than 2x historical averages, and close to the worst ever cumulative 5-year default rate, which resulted from the Global Financial Crisis.
Current Spreads Offer Compensation to Offset GFC-Type Default Rates
Source: Barings, Deutsche Bank. As of May 18, 2023. Spread implied default rates assume 40% recovery.
Opportunities Across the Market
Despite concerns about the economy, current credit market conditions are attractive across the board due to higher yields that are offering a cushion against potential downside scenarios. In particular, yields across most fixed-income asset classes are in the 80th-90th percentile versus the last 20 years, with yields on global high-yield bonds and global loans reaching 8.5% and 10.1%, respectively, at the end of the quarter3.
In the short term, however, given the potential for further Fed interest rate hikes, we see more value in loans relative to high yield bonds. Longer term, when the end of the hiking cycle becomes more apparent, fixed-rate debt will likely be more compelling. That said, floating-rate debt faces a few potential headwinds including a possible slowdown in the formation of collateralized loan obligations (CLOs) due to the decreased attractiveness of CLO arbitrage and possibly lower demand for loans due to more vintage CLOs passing their reinvestment periods.
For investors determining where to invest now, the real question concerns the liability set that is being managed. For instance, a corporation deploying cash may consider high yield bonds, while an insurance company looking to match long-term liabilities may find longer duration assets more attractive. Similarly, a pension fund may opt for the attractive coupon on offer in loans, using the regular income from a separately managed account to match predictable outflows.
Reasons for Optimism
Given the risks of stickier inflation, deteriorating earnings, and a likely recession, this is not the time to take on excessive risk to earn higher returns. However, any potential downturn is unlikely to have as negative an impact on the high yield market as some anticipate, especially since many issuers, already in a strong position, have responded to the weaker growth outlook by, for example, stopping debt growth (0% change year-over-year) and making reductions in capital expenditures (-8% quarter-over-quarter) to help preserve balance sheet quality4. The high level of consumer savings and government spending that may make a recession relatively manageable, combined with the attractive level of yields, also support today’s compelling case for fixed income.
For Professional Investors / Institutional only. This document should not be distributed to or relied on by Retail / Individual Investors. Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Barings is the brand name for the worldwide asset management or associated businesses of Barings. This document is issued by the following entity: Baring International Fund Managers (Ireland) Limited), which is authorized as an Alternative Investment Fund Manager in several European Union jurisdictions under the Alternative Investment Fund Managers Directive (AIFMD) passport regime and, since April 28, 2006, as a UCITS management company with the Central Bank of Ireland. 01/ 2991376.
1Source: Bank of America. As of June 30, 2023.
2Source: JP Morgan. As of June 23, 2023
3Source: Bank of America Merrill Lynch, Bloomberg and JP Morgan. As of June 28, 2023.
4Source: J.P. Morgan. As of March 31, 2023. Data based on U.S. high yield issuers.
