The resilience of high-yield markets

In the current economic landscape, the resilience of high yield markets is particularly noteworthy. While valuation and fundamentals are always key drivers, the technical landscape has emerged as the most powerful force—specifically supply and demand dynamics. In 2022 and 2023, market supply was net negative, an unprecedented occurrence. This year, supply, net of refinancing, remains relatively muted. But the demand for credit-related assets across all geographies and channels remains robust.

Along with strong fundamentals, the current demand is reflected in spreads to Treasuries at very narrow levels—285 to 290 basis points (bps). Throughout much of this year, spreads have ranged between 300 to 350 bps. Comparatively, in 2020, spreads were significantly higher, often exceeding 500 bps and at times surpassing 1000 bps. Yet, the inflows into the asset class this year are tracking those in 2020. Strong inflows at narrow spreads indicates a shift from tactical to strategic allocations as investors/allocators are now more interested in the long-term return and risk streams offered by credit. Historically, tactical money would enter and exit the asset class based on spread levels.

Weathering volatility

We have not seen much credit spread volatility when compared with the interest rate part of the market. We expect any backup in spreads to be limited due to strong demand. The money is flowing in at current spread levels, and many allocators are currently only making partial allocations, with additional investments expected if spreads widen. This dynamic is supported currently by solid market fundamentals and a positive economic backdrop. The US consumer is strong, with high employment rates and net worth, providing tailwinds for the market.

The default rate further illustrates the market's strength. The long-term average US high yield default rate is above 3.5%, and it currently stands below 1.4%.¹ The default rate peaked a year ago in the mid-2% range and has since drifted lower. Interest coverage is another key indicator of strength. While below their peak, current levels for interest coverage would have been near peak for any cycle prior to COVID-19.² Overall, the fundamentals are healthy, and there’s good access to capital for 90% of the market. The bottom 5% to 10% of the market still faces challenges, but the vast majority are very healthy right now.

Liability management exercises

Liability management exercises are a critical part of the high yield market. Our view is that at times it makes sense to participate— it may involve creditors locking arms together to prevent equity holders from taking advantage of them. At other times, it's some portion of the creditors joining together to put up additional capital for the company. It is important to be in a position to get a seat at the table in those situations. An investor needs the ability to put additional capital into the situation to improve their position in the capital structure.

Risks and spreads

There are a number of positive factors in the market right now, but spreads are definitely tight—we cannot deny that. Overvaluation in certain parts of the high yield market is probably a bigger risk than defaults. Over 50% of the market is BB rated.³ We have been significantly underweight BBs because the spreads often do not justify the investment. When defaults do pick up, we expect CCCs to be impacted primarily, which represent 12%-13% of the market. However, the market is already pricing in defaults in the CCCs, with bonds for some of these companies trading at deeply depressed levels.

We often look at adjacent markets if we can find better value than we see in certain parts of the high yield market. For example, it might be the BBB part of the market, the lowest rung of the investment-grade market. We have been able to find certain bonds there that are trading at spreads well wide of BBs.

The difference in spread between BBBs and BBs is relatively narrow right now. So, as we see it, an investor is not giving up much to move up in credit quality and benefits from a different source of liquidity—we like that diversification. But we are not trading up blindly; we are looking for select opportunities in investment-grade, and we are investing a bit in leveraged loans and convertibles, as well as holding a higher cash position than normal right now as we feel the opportunity cost of holding cash is still relatively low. Even though cash yields are coming down, they are still attractive in the mid-4% range. In contrast, the high yield market is offering about 7%.

Impact of central bank rate cuts

I’ve discussed a number of reasons explaining the demand for the asset class, and we cannot forget that central bank rate cuts are also a factor. Some high yield issuers have floating-rate debt. So at the margin, one reason why interest coverage is off the peak is because that debt has floated materially higher. We are seeing some relief on that side of things with the Federal Reserve (Fed) and other central banks cutting interest rates.

The equity market has been strong. The Russell 2000 Index has risen about 30% since October 27 of last year, and the S&P 500 Index is up roughly 35%.⁴ The publicly traded convertibles market is open to many high-yield issuers. In the convertibles market, you can give up some equity upside off of a very high valuation in most cases and still get the same low coupons that you were getting in 2020 and 2021. Access to capital is very plentiful right now. The bottom 5% to 10% of the high yield market has to get a little bit more creative, but even that part of the market is able to get access to capital.

Floating-rate bank loans

Digging a little bit more into floating-rate bank loans, depending on the day, they are under technical pressure right now. It is a very technically driven asset class. Other than the fact that the collateralized loan obligations (CLOs) are the largest share of that market, and represent relatively stable demand, the remaining demand is very much driven by a focus on when and how much the Fed is going to cut interest rates. You still can find some attractive valuations there, and we are finding potential investment opportunities.

Investment-grade is very much issuer-specific. As previously mentioned, an investor is not giving up much spread to move up to the BBB part of the corporate bond market. The reality is that spreads are tight in both the BB and BBB segments, so investors need to be careful and look for value. There are some idiosyncratic situations in investment-grade where we can get wider spreads and a different source of liquidity. We like to take advantage of that.

Lessons learned

In sum, the fundamentals are good now, but it's been a slow-moving cycle coming out of the COVID-19 pandemic. Corporate management teams—CEOs, and CFOs—have had more than two years to prepare for higher rates and potential recession, and they have had access to capital for virtually the entire market almost all of that time. And we've been talking about not just high-yield bonds, but also loans, private credit, convertible bonds, equity, asset-backed markets, and all sorts of access to capital. I think the market has learned a lot over the years. Management teams learned from the global financial crisis and COVID-19. I think that is why we are looking at a relatively low default rate right now.