Weathering the storm of uncertainty – how resilient is High Yield?

Recent global monetary policy has supported higher interest rates and central banks remain generally hawkish. How will high yield issuers survive this higher rate environment?

We believe one of the most important but overlooked factors is that corporate high yield issuers have had almost a year to prepare for a higher cost of capital and a potential recession. They may have several more quarters, at least, to continue to prepare. We want to make sure that corporates have the proper sense of urgency to adjust to this new environment. While the cost of capital is clearly much higher, creative CFOs who want to access capital have a number of avenues to do so – whether in the unsecured or secured part of the high yield market, leveraged loans, private credit, convertible bonds or public or private equity. Issuers also have a rare opportunity to retire existing bonds well below par with the US high yield market priced below 90 cents on the dollar. Interest coverage is at record levels because most of the high yield market was financed in 2020-2021 at very low coupons with extended maturities. These low coupon, fixed rate obligations are being serviced with inflated assets and cash flows.

Recessions typically indicate a risk-off environment. Can you explain your thoughts on the high yield asset class in relation to recessions?

First, defaults are what matter more than recessions. Cumulative high yield defaults in the two recessions in the early and late 2000s were in the 20% area. Our expectation is that cumulative defaults in the next recession will be substantially lower – maybe by half or more – than the 2000s recessions. Defaults will look more like the recession scare of 2015-2016. Further, institutional investors are often surprised to discover that high yield bonds typically outperform stocks by a wide margin going into and coming out of recessions. During and after the early 1990s, early 2000s and late 2000s recessions, the High Yield Index outperformed the S&P 500 by about 9, 13 and 13 percentage points respectively on an annualised basis. The only exception was the COVID-19 recession of 2020 during which the policy response from the administration, Congress and the Federal Reserve was so fast, furious, and sustained. Typically, high yield draws down much less than stocks and then recovers much faster. For example, high yield was back above its highwater mark by the fall of 2009 while the S&P 500 was not back above its high water mark until late 2012.

If there is increased risk of recession or weakness, why have we not seen elevated spreads akin to previous cycles?

As I mentioned before, we believe the default experience in the next recession will be something like half of the cumulative defaults seen in the two recessions in the first decade of the 2000s. The most aggressive financing has been in the leveraged loan and private credit markets.

High yield has migrated to more of BB-rated market with larger companies that are more likely to be publicly held. As I also mentioned before, most of the high yield market was financed in 2020-2021 with low, fixed rate coupons and extended maturities. These bonds are now being serviced with highly inflated assets and cash flows. Inflation is bad overall for financial assets, but it is good for credit quality especially if your debt is fixed rate with extended maturities. Managements have had and will continue to have time and access to capital to prepare for a higher cost of capital and potential recession. We just went through a default cycle in 2020. Looking back to the 2000s, investors did well when the high yield market re-priced. Further, the Federal Reserve in partnership with the administration and Congress set up facilities to directly support the high yield market in 2020, meaning investors will not necessarily get the same buy points going forward. We believe this is why we have been in a spread range between 400-600 basis points for the latter part of 2022 when historians, who may be focused past market behaviours instead of what is different today, have been calling for much wider spreads.

The dollar price of high yield seems attractive right now. Do you share this view?

Yes. High yield has spent most of the last decade near 100 cents on the dollar or higher. The average price of high yield is now below 90 cents with the absolute price level providing additional upside potential. There have only been three periods in the last decade where the dollar price has been below 90 cents on the dollar.

What do you see as the biggest downside risk to the high yield market? How would you be positioned to combat this?

One risk for the high yield market is that stress in the leveraged loan and private credit markets spills over into the high yield market. Treading very carefully or avoiding CCC risk in the high yield market is the best way to combat that risk as that is where most of the defaults come from, particularly in the past decade.

A second risk is seizing up of liquidity which could also be a spillover from another market. Holding sufficient cash, maintaining a portfolio with diverse liquidity sources, adept and nimble trading especially in illiquid environments and a focus on attracting the right kind of clients are the best ways to combat this risk.

What should investors consider when allocating to high yield?

The resilience of high yield is key. The High Yield Index usually draws down less than the S&P 500 in recessions and then recovers faster. One reason for this resilience is bondholders’ contractual right to interest and principal payments. In general, corporate management teams must satisfy these interest and principal obligations to preserve, let alone grow, the value of the company’s stock. Although cash flow and assets may be used to pay off principal, most high yield bonds are refinanced. Therefore, access to capital is usually the controlling factor. Bonds do not typically default if they can be refinanced, and there are multiple avenues available. As we approach recession, the high yield market reprices to higher yields, which attracts capital and allows managements to refinance their bonds. In addition to the bond market, management teams can refinance high yield bonds in the private credit, leveraged loan, convertible bond, or equity markets.

What role do you think high yield can play in an institutional investor’s portfolio?

A strategic allocation to high yield can be a compelling middle ground between the core fixed income and equity allocations. Over long periods of time, high yield has delivered a good portion of the upside of equities with much lower volatility and drawdowns. In long periods of equity weakness, high yield has delivered much higher returns than equities. While core fixed income has outperformed high yield in recessionary environments, high yield has recovered quickly and delivered much higher returns over complete economic and market cycles.

Tactically, profit margins and earnings are at heightened risk and equities are more sensitive to earnings risk than high yield bonds.

How has the quality of high yield changed over the years? Is it due for a re-branding?

Credit quality improvement has been significant, and the default outlook remains benign. The days where all high yield issuers were considered junk bonds are over. Now, BBs account for over 50% of the market. Secured bonds are over 25% of the high yield market and subordinated bonds are about 2%. High yield issuers are now much better businesses, often publicly traded with large market caps relative to debt.

What is your outlook for 1H2023?

We think a long pause on the part of the Federal Reserve is the most likely scenario but one that is underpriced by the financial markets. In this type of environment, during which the Federal Reserve maintains higher rates for longer before easing, we contend that looking for carry while steering away from defaults is a good strategy. Corporates have had and will continue to have time and access to capital to prepare for a higher cost of capital and potential recession, lowering default and other risks. Furthermore, the fundamentals of the high yield market remain supportive, justifying much narrower spreads than we have been accustomed to historically, even in the imminent recession scenario. Lastly, inflation is good for credit quality, particularly when so many issuers have locked in fixed-rate, low-cost, long-term financing. With yields at attractive levels, high yield continues to offer a compelling opportunity.

Interviewed by David Brannon, Head of Research, Savvy Investor.

This material was originally published in the Savvy Investor Special Report: Discovering Sources of Alpha and Diversification in Fixed Income: Industry experts discuss opportunities in a transformed fixed income landscape.