Macroeconomic forces have been key drivers of performance in the global high-yield market in recent months, but 2023 is likely to bring a renewed focus on issuer fundamentals, say Sunita Kara and Brent Finck.

Read this article to understand:

  • The outlook for high yield in 2023
  • Why improved resilience among issuers can help limit defaults
  • The divergence in performance between cyclical and non-cyclical sectors

Spiralling inflation, aggressive interest-rate hikes, Russia’s invasion of Ukraine: 2022 brought significant challenges for investors in fixed income, and high yield in particular.

The high-yield benchmark1 was down almost ten per cent in the year to December 13. Investors found few places to hide amid the fallout, with higher labour costs and commodity inflation impacting most sectors – even traditionally defensive industries such as healthcare. High-yield funds saw significant outflows.

Macroeconomic uncertainty is likely to persist in 2023. Central banks’ efforts to tame inflation through higher interest rates are weighing on economic activity in the US and Europe. As recession risks loom, slower EBITDA growth, greater margin pressures and increased funding costs are impacting corporate balance sheets, and a rise in defaults is expected.

Nevertheless, as spreads widen, higher all-in yields are likely to spur increased investor appetite, especially as central bank policy normalises and volatility subsides. While the market looks to be more resilient than during previous recessions,2 investors will need to pay close attention to the fundamentals of individual issuers. Good security selection, shrewd sector allocation and a dynamic approach will be key to outperformance over the next 12 months.

New issue market favours quality names

High-yield issuance fell sharply in 2022. As of November 30, gross issuance stood at €25.3 billion in Europe and $100 billion in the US (by comparison, global issuance surpassed $750 billion in 2021).3 We expect issuance to pick up in 2023 if conditions allow, with double-B-rated issuers likely to retain better access to funding than their lower-rated counterparts. 

Many issuers have been notably proactive and disciplined in their financial management over recent years

However, many issuers have been notably proactive and disciplined in their financial management over recent years, reducing the need to tap markets now. Even before the onset of the coronavirus pandemic, high-yield issuers capitalised on low interest rates to refinance. Most recently, the proceeds have been used to extend debt maturities rather than pay for acquisitions or leveraged buyouts.

Less than $40 billion of single-B and €10 billion of triple-C-rated debt needs to be refinanced in the US and Europe in the next two years. Among those companies that will need to refinance before 2025, higher-rated issuers form the majority; most distressed-market maturities sit between November 2024 and November 2027, giving lower-rated issuers room for manoeuvre (see Figure 1).

Figure 1: Distressed bond maturities (per cent)
Source: Aviva Investors, Aladdin BRS. Data as of November 30, 2022

Tempered default cycle

Despite relatively strong balance sheets in much of the market, an increase in defaults is likely in 2023, albeit a modest one in historical terms. 

Consensus forecasts suggest defaults will rise to levels in line with the long-term averages of four per cent in the US and 3.1 per cent in Europe (see Figure 2). Rating agency Moody’s predicts the global high-yield default rate will rise from 2.6 per cent in November 2022 to 4.9 per cent in November 2023.4

Companies with heavy loan financing and floating-rate debt are likely to come under particular pressure if interest rates continue to rise. While rating downgrades are expected in the short term, the market is starting from a position of strength with a high proportion of double-B and low share of triple-C issuers by historical standards. 

Many companies are in a stronger position than during previous downturns. Robust earnings among double-B issuers – some of them “fallen angels” that entered the high-yield universe in the wake of the pandemic – helped bring average leverage ratios down in 2022, while interest coverage also improved. (Fallen angels’ approach to leverage and capital allocation tends to be more conservative than that of typical high-yield companies.)

Figure 2: High-yield default rates

Source: Moody’s, Aviva Investors. Data as of October 31, 2022

In addition, secured bonds now make up more than a quarter of the benchmark index – recovery rates for secured bonds are around 60 per cent, compared with 40 per cent for unsecured bonds – and the average high-yield coupon is at historic lows, translating into a lower cash price index. Therefore, even if default patterns follow historical recession averages, the overall probability of loss-given-default is likely to be lower than past crises.

Differentiated earnings outlook: Cyclical and non-cyclical

Companies in most sectors will face stern tests over the coming months. The US is heading for a consumer-led slowdown as the Federal Reserve hikes interest rates. Europe faces both a consumer- and industrial-led recession, due to higher gas prices following the conflict in Ukraine.

Unlike the COVID-related downturn in 2020, when governments offered direct handouts to citizens as part of large-scale fiscal stimulus packages during lockdowns, consumers have not been afforded much support to maintain spending. Consumer cyclical companies are therefore expected be the hardest hit. 

Retail and leisure industries are facing higher labour costs as well as earnings uncertainty

Companies in the retail and leisure industries are facing higher labour costs as well as earnings uncertainty, while cyclical advertising businesses, such as those in the media sector, are also coming under pressure. This is already reflected in bond valuations in these sectors, but there could be further underperformance if recessions prove especially deep and long-lasting. 

Prospects for the automotive sector look a little brighter, with new vehicle sales holding up relatively well, although higher financing costs and persistent supply chain issues for key components may bring further difficulties. 

Non-discretionary parts of the market, like healthcare and consumer staples, look to be comparatively well placed.  While energy companies should continue to benefit from high commodity prices, we believe most of the balance sheet improvement is now complete, and more capital will be directed towards equity returns going forward.  In 2022, we have seen high volumes of “rising stars” in the energy sector moving from high yield back into investment grade. That trend looks set to continue into 2023, albeit at a slower pace. 

Our positioning: Resilient and agile

In an environment of rising defaults and continuing economic uncertainty, our bias is towards higher-quality double-B- and single-B-rated credits, especially those in non-cyclical sectors. 

In addition, we will maintain a highly selective allocation to triple-C-rated bonds. While default rates are much higher in this bracket, these bonds offer a relatively high credit spread compared with double-B names, which can help compensate for the additional risk. 

It is, nevertheless, important to be discerning; a granular understanding of the fundamentals of each issuer is vital for good credit selection in this part of the market. There is no need for investors to aggressively chase yield in triple-C names when the higher-quality parts of the market are attractive on a capital and income perspective. 

Investors must be ready to respond to new developments at a macro level

As well as paying close attention to issuer fundamentals, investors must be ready to respond to new developments at a macro level. For example, it is possible we may see a desynchronisation between the US and Europe given the latter is more exposed to exogenous threats, including continued geopolitical conflict, sovereign risk and energy crises. All these factors could push spreads wider. Gas rationing in Europe over the winter months could cause additional stress on companies across the continent, on top of further rate rises from the European Central Bank.

Investors who can remain nimble and agile in their tactical allocations could capitalise on this regional divergence. For example, in 2022, reverse Yankees – bonds issued by US companies in Europe – provided consistent relative-value opportunities over dollar bonds from the same issuers. This is because spreads of euro-denominated debt within their multi-currency funding structures were pushed out wider along with the rest of the European high-yield market.

Ensuring we have ample liquidity is another key focus, allowing us to be opportunistic to take advantage of market dislocations. 

ESG considerations will continue to form a key part of our approach

Environmental, social and governance (ESG) considerations will continue to form a key part of our approach. Given the high-yield market is largely in private hands, with many small issuers, a focus on governance is one way for investors to ensure they have sufficient downside protection. That will remain true in 2023, when careful due diligence and active credit management will be more important than ever.

As 2022 has highlighted, trying to predict the way a year will pan out is fraught with difficulty. Our current expectation is that high-yield credit spreads will widen but investors should see a stronger total return in 2023 because the all-in yield is essentially double this time last year. But, heeding the lessons from the past 12 months, we will be prepared for the unexpected.

References

  1. Bloomberg Global High Yield Excl CMBS & EMG 2% Cap Index
  2. Sunita Kara, ‘High yield: Has the risk of capital loss from defaults reduced?’, Aviva Investors, September 7, 2022
  3. Patturaja Murugaboopathy, ‘Global high yield bond issuance slumps to lowest in 13 years’, Reuters, May 26, 2022
  4. Source: Moody’s, Barclays. Data as of November 30, 2022. The illustration of the Global HY 2% Index Spread and the Average Spread are obtained from BRS Aladdin. Indexes are unmanaged, do not reflect fees and expenses and are not available for direct investment. For index definition, see appendix. The Issuer weighted Global Speculative Grade Default Rate is obtained from Moody’s and involves historical data dating back to January 31, 1988. The default forecast is provided by Moody’s for the period from November 30, 2022 to November 30, 2023. The default forecast is hypothetical, does not represent actual data and is not a guarantee of future results. Actual results may vary significantly. This information is based on macroeconomic and index constituent information of which the results may or may not be realised and is subject to risk

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