In early 2022, the high yield market sold off due to rapidly increasing Treasury yields. In the second quarter, the sell-off was led by spread volatility – risk aversion from inflation, growth, and geopolitical concerns. However, high yield issuers remain fairly healthy. In fact, despite elevated volatility, the high yield market broke several records including lowest default rate, highest recovery rate, and highest interest coverage ratio.1
High yield will not be immune to an economic downturn, but it seems as though a lot of the damage may have already been done. Prices reached a 15-point discount in early July. The thing about bonds is they have maturity dates. Either their principal is repaid or they default, and at deeply discounted prices with low default expectations, there is the potential to realize outsized returns. High yield issuers started from a position of strength – there simply wasn’t enough time for companies to overextend themselves since the last recession. Solid fundamentals, low dollar prices and a supportive technical backdrop make high yield worth a look.
Figure 1: Yield, Spread, and Price
Source: FactSet, 7/22/12-7/25/22. High Yield represented by ICE BofA US High Yield Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
The yield and average price of the US high yield market are at levels not seen since the pandemic. Spreads approached 600 bps this month but have since sharply tightened by 100 bps to 495 bps. While this is around historical averages, it is important to take into account the composition of the high yield market. Figure 2 shows that the percentage of CCCs in the market has decreased over time – meaning the overall quality of the asset class has increased, which would imply tighter credit spreads, all else equal. An average spread of 500 bps today does not mean the same thing as a 500 bp spread 20 years ago.
Figure 2: CCC Weighting has Declined
Source: ICE Indices, 2002-2022
Nevertheless, we view the high yield opportunity to be one of prices rather than spreads. Bonds have maturities, and whether bonds get called or refinanced prior to maturity, doesn’t change the fact that prices are being “pulled to par”. Simplistically, lenders will either be repaid, or the issuer will default. As a result of this notion, discounted prices have led to attractive returns, historically speaking. The median forward 1 year return when prices were between 80 and 90 is 21.5% as shown in Figure 3. When prices were between 90-95, the median return is 12.8%. Longer time horizons have led to even more compelling results.
Figure 3: Lower Entry Prices have Led to Greater Returns
Source: FactSet 7/30/99 - 6/30/22. High Yield represented by ICE BofA US High Yield Index. Returns are cumulative.
Of course this could be a case of “you get what you pay for” but we don’t believe it is because prices are not commensurate with the overall health of high yield issuers. The default rate is 0.76% as of 6/30/22, but it is increasing. JP Morgan is forecasting a default rate of 1.25% and 1.75% in 2022 and 2023, respectively. These forecasts are still well below the long-term average of 3.2% (JP Morgan, as of 6/30/22). Credit trends have weakened somewhat, but upgrades far outpace downgrades. The 12-month upgrade/downgrade ratio is off of its recent record level, but still very high. In June, there were 23 upgrades and 20 downgrades – still more upgrades than downgrades. The broader credit risk profile of the US high yield market continues to remain strong - 25% of issuers are in the S&P 500 and 2/3 are public companies.
Figure 4: Upgrade-to-Downgrade Ratio is just off of its Record High
Source: J.P. Morgan; Moody's Investors Service; S&P
As volatility across risk assets picked up, new issuance has slowed down. With record low yields in 2020-2021, there was an extremely large volume of refinancing, effectively pushing out the “maturity wall”. Consequently, there are relatively few issues coming due in the next few years meaning many issuers do not need to refinance debt. Those issuers can be patient and wait until credit conditions improve, resulting in very light issuance.
Further, there has been an abundance of rising stars which are high yield bonds that get upgraded into investment grade. Kraft Heinz, HCA and T-Mobile all had over $10bn of debt become rising stars and move to investment grade.2 Potential upgrades include Occidental Petroleum and Centene which both have greater than $15bn of outstanding bonds. As shown in Figure 5, the high yield market has already contracted by 8% in 2022. Due to both light supply and rising star expectations, the market may continue to contract which is supportive of high yield from a technical standpoint.
Figure 5: Light Issuance and Rising Stars Provide a Positive Technical Backdrop
Source: J.P. Morgan
With all of the uncertainty still in the marketplace, some advisors may feel a more cautious approach to high yield is warranted. Perhaps legging in with short duration high yield would be preferable for them.
Figure 6: Less Risk, Less Yield Give-up
Source: FactSet 7/25/22.
Short duration high yield historically has had lower volatility and less downside participation than the broad high yield market. 3 The trade-off is that this segment, characterized by its exclusion of CCC-rated bonds and issues closer to maturity, is that it generates less yield. Currently, the yield differential is fairly small meaning there isn’t much yield give-up for potentially better downside mitigation.
This year has been one of records for high yield – some good and some bad. It is fair to say that most did not expect the high yield market to be where it is right now. However, market dislocations create opportunities. The opportunity right now is that issuers are going into this uncertain environment from a position of strength with a supportive technical backdrop. We believe deeply discounted prices do not reflect this strength and therefore, the high yield market can potentially provide a favorable investment outcome.
1 JP Morgan
2 BofA Securities
3 FactSet
About Risk
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity. Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and are more vulnerable to changes in the economy. The Fund may invest in derivatives, which may increase the volatility of the Fund’s NAV. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
Definitions
ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
The ICE BofA 1-5 Y BB-B Cash Pay HY Index tracks the performance of BB-B rated U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market with maturities of 1 to 5 years.
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates.
“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.