1. High yield spreads have stayed remarkably tight despite rising recession risks. How long do you think spreads can hold in?
High yield spreads generally reflect the premium investors demand for accepting the risk of capital loss due to defaults. We see a number of factors that have contributed to the persistently low level of high yield spreads.
- Easy monetary policy. In the wake of the pandemic, easy Federal Reserve policy drove interest rates lower. Many high yield credits extended maturity walls out and reduced interest expense. This helped pave the road for defaults to reach cycle lows.
- Average dollar price/quality. Looking at the past 20 years, the average dollar price of the Bloomberg High Yield Index is now the lowest it’s been at a time when spreads have been at current low levels.[i] We believe this contributes to an attractive “margin of safety” in the current high yield market, which is helping to keep a ceiling on spreads. Furthermore, the lowest-quality (rated B+ and lower) cohort within the Bloomberg High Yield Index remains at the lowest levels since 2007.[ii]
- Issuance. A lack of net new issuance in 2022 shrunk the size of the high yield bond market.
Looking ahead, we see catalysts that could move spreads wider. If corporate profitability begins to meaningfully deteriorate in the coming quarters, we expect market participants to demand higher spreads to compensate for the perceived increase in default risk. Furthermore, if the current regime of higher interest rates continues, many over-levered capital structures that were built during an ultra-low-yielding environment will likely struggle to refinance their bloated balance sheets and profitably operate at higher costs of interest expense. Weakness in these structures could affect sentiment across the high yield market.
2. Markets seem to be anticipating a relatively shallow downturn. What kind of default rate are you expecting in 2023?
We’re expecting a below-average default rate compared to previous late cycle/downturn environments. Gross leverage remains near cycle lows in the high yield market while interest coverage ratios remain at cycle highs.[iii] Corporate balance sheets appear healthy and profitability has been resilient in the current inflationary environment. In our view, index composition should support a lower default rate; as we mentioned above, the higher-quality index skew and our assessment of the “margin of safety” provided by the low index dollar price compare favorably to history. Finally, the use of proceeds from new issuance over the past few years has lacked the lower-quality leveraged buyout/equity monetization that the market experienced in the mid-2000s.
One area of concern is the Federal Reserve’s most recent Senior Loan Officer Opinion Survey on Bank Lending Practices, which indicated that loan officers are tightening their lending standards. Typically when lending tightens, spreads move wider, but this correlation decoupled in the last reading.[iv] This suggests high yield spreads and default expectations may be diverging from current market valuations. We’ll be watching this indicator closely.
3. The high yield bond universe contracted in 2022 due to low issuance and rising stars. Do you see a reversal of these trends happening any time soon? Why or why not?
The market seems to expect these trends will continue—JP Morgan recently forecasted that the high yield bond universe will contract for the second year in a row.[v] We don’t disagree that the market will contract, but we see potential for issuance to pick up. Now that US Treasury rates have “normalized” from historically low levels, we would expect some of the issuance that has flooded the bank loan market during the past couple of years to return to the high yield market. We also expect rising stars and fallen angels to be more balanced in 2023.
[i] Bloomberg, 20 years ending 5 January 2023.
[i] As of 31 December 2022.
[iii] Factset, Goldman Sachs Global Investment Research, December 2022.
[iv] Federal Reserve Board, Senior Loan Officer Opinion Survey on Bank Lending Practices, October 2022.
[v] JP Morgan, December 2022.
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