High Yield Credit Outlook: Compelling Carry & Structural Tailwinds

1. What’s your overall view of the high yield market as we enter the year?

Spreads are tight, but we think high yield credit offers compelling carry if the economy can avoid recession this year. Convexity, a measure of the sensitivity of bond prices to changes in interest rates, is something we talk about often. We think it looks really good right now, and we expect it’ll continue to be a nice tailwind for the high yield sector. From a technical standpoint, we anticipate higher net new issuance compared to 2023, with coupon pressures set to subside.

Corporate fundamentals look solid in our view, and our default expectations for 2024 are generally in line with what we saw in 2023. Our models are showing the beginnings of a positive trend in corporate losses, which we see as an encouraging sign. That said, we’re not complacent about default risk and we’re keeping a close eye on corporate profitability.

2. Is there anything unusual happening in the market that stands out to you?

In the high yield bond market, low dollar prices typically go hand-in-hand with wider spread levels relative to history. Today’s market is interesting because average dollar prices are low, but spreads have remained tight. We think this dynamic can provide a structural tailwind that you don't usually get in a tight spread environment.

We believe low dollar prices can provide some potential downside protection against credit losses. For example, when a default occurs, the recovery value is typically lower than the price paid for a bond. With average bond prices below historical ranges, the smaller gap between the price paid and the potential recovery price could help protect against credit loss. Since the economy has demonstrated some ability to absorb higher rates without going into a downturn, we believe current prices could offer a nice entry point for credit investors.

3. What are the main risks you’re watching going into 2024?

One of the biggest risks we’re watching is the potential for slower growth or recession. The market seems increasingly optimistic about a soft landing in 2024, but what if inflation proves more stubborn than anticipated? If inflation surprises to the upside, the Federal Reserve might remain on pause for a longer period of time, leading to slower growth. We think that would be a negative for market sentiment and would likely lead to wider credit spreads. We’ll be keeping a close eye on credit losses and understanding how inflation impacts corporate profitability going forward.

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