Be on the lookout Be on the lookout\images\insights\article\mountains-man-overlook-small.jpg April 28 2023 January 26 2023

Be on the lookout

An improved high-yield asset class might not flash the same signs for reentry as in past economic downturns.

Published January 26 2023
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It will come as no surprise that the U.S. high-yield market is behaving atypically ahead of the economic slowdown. After all, atypical is the name of the game since Covid emerged. We think the time to add back to the asset class will come soon, but the signs likely won’t be as obvious as usual.

Whether the economy slides into a true recession or not, we expect default rates to increase from their all-time low levels of 0.70% in 2021 and a still-subdued 1.65% last year (J.P. Morgan) to around 3.5-4%. Downgrades are now running ahead of upgrades, earnings are coming under pressure and we expect credit stress and widening of spreads (the gap between rates on high yield and comparable maturity Treasuries). But we don’t think the situation will deteriorate to the levels of previous cycles, in which defaults reached around 8% and spreads topped 1,000.

Obviously the likely mild nature of the downturn has much to do with it, but there are other reasons. For one, credit metrics of high-yield issuers are comparably stronger entering the current period of potential economic weakness. But another factor is that the asset class has evolved, with rating breakdowns improving over the last decade. BB-rated securities are now a greater percent of the market than CCC-rated bonds. Also, the typical end-of-cycle leverage buyout surge didn’t occur this time as investment-grade strategic acquirors using low capital costs tended to win bidding contests over their private equity counterparts. Bond math also comes into play. The Credit Suisse High Yield Index has a price in the high 80’s but most of it a result of the increase in interest rates last year. With an average maturity of a little over five years, eventually the march to 100 at maturity becomes a strong factor.  

Also, the high-yield space has become more mainstream over the last few decades. High yield used to be very opportunistic, skirting the edge of respectable issuers and avoided by most investors. Today many big platform clients include it as part of the allocation mix.

If it does turn out that the high-yield market doesn’t trace previous tightening cycles, then timing the market could prove difficult. Investors may want to start adding before the ultimate high in spreads as that opportunity may come and go quickly given the recent increase in volatility. Yes, the preeminent issue for allocating to high-yield bonds is the economy and we are closely monitoring earnings and earnings outlooks as we progress through 2023. Near-term weakness could lead to spread widening, which should present an attractive entry point. Historically, peak spreads don’t last long!

Tags Fixed Income . 2023 Outlook . Interest Rates . Monetary Policy . Markets/Economy .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Bond credit ratings measure the risk that a security will default. Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings of BB and below are lower-rated securities; and credit ratings of CCC or below have high default risk.

The Credit Suisse High Yield Index is designed to mirror the investable universe of the U.S. dollar-denominated high yield debt traded in the U.S. credit market. Indexes are unmanaged and investments cannot be made in an index.

Effective Duration: A measure of a security’s price sensitivity to changes in interest rates. One of the methods of calculating the risk associated with interest rate changes on securities such as bonds.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.

Federated Investment Management Company