Don't call it a comeback...yet
We believe next year could present compelling opportunities within high yield.
All things considered, the high yield market actually has had an OK 2023, with total returns pushing 7% in a year when interest rate increases hit higher quality bonds and a resilient economy helped spreads (the yield gap relative to comparable maturity Treasuries) tighten somewhat. Looking ahead, however, we see plenty of headwinds that the asset class will likely have to overcome before we turn bullish on its prospects.
First and foremost is the economy. We anticipate weakening growth into 2024, with the odds-on bet being a modest recession (although one cannot count out a harsher outcome) in the new year. In fact, the single biggest tail risk to high yield would be a worse-than-expected economic scenario with much higher default rates and much wider credit spreads. Many forward measures of economic growth continue to flash warning signs. The U.S. consumer, whose strength has been the linchpin of the post-pandemic economy, is exhibiting signs of fraying around the edges, with auto and credit card defaults on the rise. Abroad, the story is not much different. European economies are stagnating across the board. China continues to struggle with a soft reopening and issues in its domestic real estate market.
Within markets, leveraged loans, equities, commercial real estate and private credit are all areas of concern to varying degrees. Negative surprises in any of these areas can quickly bleed into high yield. Loans are especially worrisome, despite their strong year-to-date performance. A recent Standard & Poor’s report noted that 21% of B-rated companies were struggling to generate enough earnings to cover their interest costs. Despite their recent run after a relatively strong Q3 earnings season and decline in longer yields, equities also remain volatile. In the high yield arena, earnings beats didn’t generate much upside and misses were dealt with harshly. And floating-rate credit markets continue to show rate-related credit deterioration. All worrisome.
Now for the silver linings. Despite the above, we have reason to believe that an attractive entry point to high yield could develop sometime in 2024. It may take patience, as we expect higher for longer to be the prevailing narrative well into the new year, with inflation remaining sticky to the upside. This should make for lackluster high yield returns and modest outflows. However, this weakness should be less pronounced than historically has been the case in deteriorating economic environments. For one, spreads continue to run below long-term levels, and the ratio of high yield credit downgrades vs. upgrades has flattened—both signs of a durable market. Moreover, with the more aggressive deals being financed in the leveraged loan and private credit markets, the high yield market by comparison is higher quality, with supply constrained, demand resilient and average maturities reasonably short. All this suggests that as the economy slows and potentially enters recession, the accompanying spread widening and relative valuations could make high yield too attractive to pass up. That’s when we’ll turn bullish.