Brent Finck and Sunita Kara consider the implications of a potential tightening of credit conditions on the global high-yield market and why a high-quality bias remains prudent for investors.
Read this article to understand:
- Why our base case remains for only a modest rise in HY defaults
- Why issuers need to be proactive in getting ahead of upcoming debt maturities
- How the positive convexity of the asset class could reward patient investors
With inflation proving stickier than expected, the prospects for central banks cutting interest rates have been pushed out to the end of the year. Throw into the mix an unexpected crisis in the US regional banking sector in the Spring, which some commentators believe could lead to a tightening in credit conditions, and it becomes clear why the recovery in performance of risk assets has been a stop-start affair this year.
But what does this all mean for the global high-yield (HY) market? We put the questions to Brent Finck (BF) and Sunita Kara (SK), global co-heads of high yield at Aviva Investors.
Has your view on the direction of rates changed since the start of the year and how is it impacting HY spreads and yields?
BF: We are seeing stickier inflation than we hoped. This is putting central banks in a difficult position, as they need to balance recessionary pressures with managing inflation. A strong labour market is making that job even harder.
The rates market has been aggressive in terms of pricing in how fast central banks would cut rates, in anticipation of a recession or a harder landing. However, the spreads of HY bonds imply a much more sanguine outcome, by not pricing in a meaningful slowdown in macroeconomic activity.
Typically, in a recession, credit spreads go to about 800 basis points (bps). Currently, spreads are at about 450bps for our benchmark. Part of this is because the market has higher quality names and less triple-C companies than past cycles and there are other sources of capital companies can tap into.
SK: The complexity on rates and spreads was made worse because of the banking crisis in March. The direction of travel is probably the same, where essentially corporates are dealing with a higher cost of funding, but there has been a slight handoff between the banking system and central banks.
The environment is not supportive of tighter spreads - yields are essentially double where they were 18 months ago. These flags and catalysts are known, but it's certainly not a gradual process.
In an environment of potentially slower growth and lower bank lending, is your expectation still for only a moderate increase in defaults?
SK: We expect a moderate increase in the default rate to around 4.5 per cent, not far off the long-term average. That is different to past crises where we saw double-digit default rates. Even during COVID-19, when the situation was well managed by governments, the default rate peaked around six per cent.
What’s different this time is that balance sheets have been more conservatively managed coming out of the pandemic. Most corporates haven't levered up as much as they would typically leading into a downturn. There are still some situations where companies have too much leverage and need to resize their debts, but on the whole, we are comfortable with corporate fundamentals in this downturn.
BF: Our universe is fixed rate; we do not have much floating-rate exposure. However, the leveraged loan market is an asset class correlated to ours, which is floating rate. Borrowers in that market will see increased pressure on their interest coverage or ability to service their debt and that could have spill over effects into our market.
A significant part of the market will mature over the next several years and need to be refinanced
It is also worth highlighting a significant part of the market will mature over the next several years and need to be refinanced. In the near team, though, this is manageable and not a problem. 2025 is a big year for HY bond maturities and companies need to be proactive in addressing that over the next 18 months.
What does that mean in practice? Many companies will come to market and bite the bullet to pay high coupons. They will get support from their private equity sponsors or shareholders to help recapitalise the business and reduce their debt burden. Others will consider strategic alternatives, including selling their business in certain circumstances.
These maturities will factor into how companies think about their business profiles going forward. Lower-rated companies are heavily incentivised to pay down as much debt as soon as possible. Higher-rated companies have more options; their access to capital is stronger and they can perhaps be more patient in when they come to market.
You mentioned M&A. Would that be skewed towards better quality names?
BF: M&A can cut both ways for HY. Often, it involves a higher-quality company buying a weaker one, which generally is a positive investment catalyst for HY bonds.
At other times, consolidation can be detrimental to bondholders. Unfortunately, covenant quality is not as strong as it was a decade ago, which is something to be mindful of.
More recently, however, we have seen the investment community demanding tighter covenants, such as limiting the ability to strip assets out of the company, to take restricted payments and demanding tighter controls over how the business is run. That is a positive development, as the power is shifted back from issuers to buyers.
Issues in the US regional banking sector have had wider market impacts, one of which has been to make accessing the HY primary market more challenging in the near term. What are your expectations for new issue activity, both in terms of volumes and pricing?
SK: Higher volumes and higher costs are the general theme. We have been through two years of suppressed volumes. Last year was one of the worst for HY, both from a total return perspective and for outflows.
The environment now is one that is more costly for issuers; they must address maturities coming up and if they wait too long, it will be negative for accounting purposes as that liability becomes current and causes audit issues. The market doesn’t like to see that in credits, even on very distressed names. It likes to see a good 18-month runway at least.
We are about 100bps tighter in terms of spreads and have seen the gates open for primary issuance
Since the banking crisis, we are about 100bps tighter in terms of spreads, and have seen the gates open for primary issuance across the rating spectrum and industries.
However, funding costs have not come down as quickly as issuers were expecting at the start of the year. Inflation is still above target and the likelihood for much lower rates in a year’s time is low. Once the market is pricing in cuts, it doesn’t necessarily mean that your overall yield will fall if your spreads are slightly higher.
This is the new funding area, where double-B bonds pay around six per cent, single-B bonds pay low double digits and triple-C is case by case.
There has been a divergence in performance in the US between bonds from lower- and higher-rated issuers since the banking crisis. Is this due to concerns over recession or other factors? Has the threat of zombie companies finally come to pass?
BF: This year we have seen both sides of the coin. Earlier in the year there was a risk-on rally, where lower-quality bonds outperformed; triple-C returned more than twice the total for the market in January. But with the onset of the banking crisis, there were concerns about the availability of capital for lower-quality issuers. More recently, the theme has been a return to quality.
Triple-C bonds are still outperforming, but we remain cautious on those companies because they are the most sensitive to a recession
Triple-C bonds are still outperforming, but we remain cautious on those companies because they are the most sensitive to a recession. You have to stress these companies in terms of your idiosyncratic credit selection, and that is why we rely heavily on our analysts to make sure our style is cautious and avoids downside. That has contributed to us having a lower default-related loss than the market every year.
SK: The threat of zombie companies has not passed. Some companies were afforded a lifeline for several years when funding costs were cheap. Now, as they start factoring the true cost of running the business (higher labour and raw material costs), margins are going to be lower. They may find they can no longer operate with their current capital structures.
In our recent article, Focus on the fundamentals, you said higher all-in yields should spur increased investor appetite as monetary policy normalises and volatility subsides. How do you view conditions now?1
BF: We still like the all-in yield of the asset class. It is roughly 8.5 per cent, which gives a buffer or a shock absorber to weather spread widening or higher interest rates. At the same time, credit spreads on a standalone basis are not reflective of some of the macro risks.
We have tempered our forecast because we have already seen a four per cent total return since the beginning of the year. We have pulled forward some of the upside of the asset class, but we do not think investors should expect a negative total return going forward.
You have a high-quality bias, including towards fallen angels. Given the macro backdrop, do you expect to see a pickup in the number of fallen angels from the IG universe?
SK: We expect the macro picture and fundamentals to deteriorate. But we are certainly not expecting a type of scenario with strong ratings migration from IG into HY, akin to what we saw during the COVID-19 period.
Just as HY companies have been conservative with their balance sheets, the same has happened with IG companies. Usually, they have more levers to pull, for example they can cut dividends and have non-core assets that can be sold.
In the past, triple-B and double-B companies could access the market in the same way. The funding gap between the two was minimal. Now the difference is more meaningful. Companies do not want to step down into HY, so they will be more proactive in retaining their ratings.
BF: The volume of upgrades of triple-B companies have outpaced any other rating category; companies are protecting their rating to make sure they maintain IG status. While we had some fallen angels this year, the number of rising stars is outpacing fallen angels from a total amount of debt.
In more challenging periods, you’ve favoured non-cyclical names given the expectation they will be more resilient. How much of a divergence is there in performance between cyclicals and non-cyclicals?
SK: In the first quarter, consumer cyclicals were up 4.8 per cent, while non-cyclicals were up 3.7 per cent. There are a couple of reasons for that. Within cyclicals, two sectors performed well – leisure and autos. The outperformance of leisure started last year with the reopening of borders and economies after the pandemic. For autos, there is still a strong order book for new vehicles. These are trends that could come off quickly, but earnings and output are currently healthy compared to expectations.
Consumers still have a preference to buy services over goods and we think that will continue in the near term
In the context of strong labour markets, consumers still have a preference to buy services over goods and we think that will continue in the near term. Another reason that non-cyclical names have underperformed is that pharma, healthcare and supermarkets have a few idiosyncratic names in the distressed category.
Have you made any significant changes to portfolios this year?
BF: We have added some consumer non-cyclicals, in particular consumer products and food. They have weathered some of the inflationary storm they faced last year and are poised to be more defensive. On energy, we were overweight most of 2022, but trimmed that due to how much the sector outperformed last year. OPEC’s decision to cut production should help restore the balance of supply and demand, which could be an opportunity to increase our exposure once again. High-quality tilts generally come through as we progress through the year.
We also like European high yield over US HY. Historically, European HY trades tighter over the long term. Recently, this shifted due to fears related to the war in Ukraine and energy price shock. Those higher spreads have persisted, offering opportunities within Europe. Our strategy is 100 per cent currency hedged, and right now there are benefits to hedge euros back to dollars.
SK: It is worth reiterating the positive convexity of the asset class [where bond prices increase more when yields fall than if the reverse was the case]. The asset class is trading around 88 cents on the dollar. Investors must be careful with security selection, but the positive convexity and the pull-to-par on non-defaulted bonds is an uncommon and exciting opportunity for long-term investors.