CONTRIBUTORS
Bill Zox, CFA
Portfolio Manager,
United States
Katie Klingensmith
Senior Vice President, Investment Specialist
Brandywine Global
After strong performance since the fourth quarter of last year, US high yield spreads remain tight. However, Portfolio Manager Bill Zox tells Investment Specialist Katie Klingensmith that spreads are not the only consideration. He discusses several important factors that are constructive for high yield. A summary of their conversation is included below.
Although credit spreads recently widened somewhat, strong performance since the fourth quarter of last year has left US high yield spreads tight. However, spreads are not the only consideration. Strong technicals and a number of important factors remain constructive for high yield.
Strong outlook and fundamentals
While there is no denying that credit spreads are tight, there are other important factors that are quite constructive, leading to considerable strength and a favorable outlook for the high yield market. Yields in the US high yield market are around 8.3%, which is very compelling.1 The dollar price at just above $0.91 also is an attractive price for credit.2 High yield is further supported by strong fundamentals. Defaults have leveled out in the mid-2% range, which is well below the long-term historic average.3 Lastly, demand remains robust, particularly from outside of the US, while net supply has been muted in comparison.
High yield management teams have had nearly two years to prepare for higher interest rates and potential recession. Most have had good access to capital with the exception of the bottom 10% of the high yield market. Spreads are tight, and that certainly is an important risk that managers have to address. However, low defaults, strong fundamentals, and favorable supply and demand dynamics leave plenty of opportunity in the high yield market. Furthermore, we think the supply and demand fundamentals will continue to be favorable going forward.
Does interest rate volatility pose a risk?
The most important issue for credit is whether the Federal Reserve (Fed) is done hiking. In our view, the Fed clearly does not want to hike further. However, the timing and the amount of rate cuts is uncertain, which has caused an uptick in interest rate volatility in recent months. That kind of interest rate volatility is less of an issue for credit and more of an issue for core fixed income. With around an 8.3% yield in high yield, 4.65% for the 5-year US Treasury, 4.6% for the 10-year US Treasury, and just over 5% for cash, investors must make some assumptions around potential capital gains and rate cuts to justify moving out of cash. But starting with an 8.3% yield and very limited defaults in the high yield market likely is an easier step to take for investors.
As long as one avoids the defaults, the significant excess yield for high yield compared to cash allows time to see how the various macroeconomic factors play out. And it is not overly difficult to steer away from defaults since they generally are coming from the bottom 5 to 10% of the market.
Impact of "higher-for-longer” rates
The US high yield market is largely a fixed-rate market. Much of the financing was put in place in 2020 and 2021 at very low coupons. The market has largely addressed 2025 maturities and is making great progress on 2026. Many other bonds with low coupons are not coming due until 2027 or 2028, and most issuers have spaced out their maturities. So, with a fixed-rate capital structure, the incremental cost of capital from higher-for-longer rates is not that material. If rates continue at these levels into 2026 when these later maturities start to be addressed, the incremental cost of capital will increase. But for a fixed-rate borrower, there are a few more years before it becomes an issue. However, higher-for-longer rates will be more of an immediate concern for floating-rate debt, like the loan market and private credit, particularly if the floating-rate risk has not been hedged.
Global implications of rate divergences
Maturity walls have not been addressed to the same extent outside the US, likely because the issuers expect rate cuts to start soon. Once rate cuts begin, we assume issuers will become more aggressive about refinancing their maturities. Issuance has been limited outside the US, but that could pick up once the central banks start to ease. That also could lead more US issuers to consider issuing some debt in other currencies and markets, creating more global opportunities.
Risks to the outlook
The last few years appear to have been an extended normalization period, not an actual default cycle. However, a recession over the next 12 to 18 months is still possible. The question is whether we would see a true default cycle at that point.
The big capital structures pose another risk as their debt is not sustainable at current interest rate levels. We likely will see defaults in this part of the market along with liability management exercises to address excessive leverage. While this is probably the biggest risk in the market, it also is a very significant opportunity if you are in the right part of the capital structure, and you are invested at the right price. We are looking for opportunities in this space, but one advantage of our approach is that we can avoid these big capital structures if we do not see the opportunity.
Opportunities in high yield
When spreads are too tight, you typically have to sell and look for opportunities where the spreads still represent reasonable value. Right now, that means combing through the laggards to identify those that still offer value. These opportunities, which are laggards for some invalid reason, did not benefit from the tremendous rally in risk assets since late October of last year through March of this year.
One example is the cable industry. Currently, there is a negative feedback loop between the debt and the equity. The weak equity is leading to wider credit spreads, and the wider credit spreads likely are causing concerns for the equity holders. While the cable industry does face some competitive pressures from fixed wireless and fiber overbuilders that have intensified in recent years, the underlying strength of the business is still there. That cable connection delivering high speed internet to homes is still a valuable asset, in our view. Management teams must start focusing on bringing their credit spreads in, and that likely will improve the multiple on the equity as well.
Endnotes
- Source: ICE BofA US High Yield Index as of April 22, 2024.
- Ibid.
- Ibid.
Definitions:
High yield, or below-investment grade bonds are those with a credit quality rating of BB or below.
The ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
Maturity is the agreed-upon date on which the investment ends, often triggering the repayment of a loan or bond, the payment of a commodity or cash payment, or some other payment or settlement term.
A maturity wall refers to a scenario where a significant number of loans and bonds are reaching their due dates and maturity dates, raising concerns among investors about the ability of heavily indebted companies to repay or refinance.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.