Too soon to add to high yield Too soon to add to high yield\images\insights\article\man-looking-at-dark-clouds-small.jpg October 18 2022 October 18 2022

Too soon to add to high yield

As they bide their time, investors should focus on strengthening portfolios.

Published October 18 2022
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Despite the temptation of a rate cycle that appears to be nearing a peak, we continue to remain defensive in high yield. Too many macro headwinds and policy uncertainties (inflation, hawkish Fed, war, challenged earnings/shrinking margins, recession, etc.) to get bullish. With quarterly earnings and guidance now pouring in, and Fed policymakers set to meet again in early November, the next several weeks should provide clarity on when and if to make a move.

As we wait, we’re also keeping a close eye on default rates and spreads. On the former, we think default rates could migrate toward 4-5% over the next 12 months, up from the sub-1% level in 2021 and their long-term average 3% but well below high-single-digit/10% levels of past economic crises. If anything, history would suggest 4-5% may be underestimating what may come if the economy enters recession. But when taking to our analysts who cover specific industries, they believe 4-5% is too high as corporations generally entered this downtrend in strong financial position, with higher overall credit quality compared to past cycles and the lack of any really stressed sector. In 2008, big, overpriced leverage buyouts fed defaults. In more recent cycles, energy accounted for a disproportionate share. This time, no sector seems to be in dire straits. With job growth historically robust, joblessness below 4% and household balance sheets also relatively strong, a mild recession seems the best bet. Still, even these environments can produce surprises, often to the negative side. Just ask the U.K.

Spreads—the gap between rates on high yield and comparable maturity Treasuries—are running about 550 basis points, roughly 50 basis points above the historical median. With recession prospects and Fed terminal rate predictions both climbing, the bias remains for further widening. Spreads have been volatile—they rallied strongly mid-summer, plunging from cycle highs to below median before abruptly reversing. Along with liquidity issues in the bond market, it’s not hard to envision the potential further gapping in spreads. Still, at this juncture, we aren’t expecting nor will wait for 1,000 basis-point spreads before increasing high-yield exposure. Several factors argue for a potential lower entry point than in past cycles. In addition to the expected lower peak default rates, high yield issuers entered this period in a strong financial position relative to past cycles and the overall high yield market is of higher quality than past cycles as evidenced by a higher percentage of BB-rated securities and a lower percentage of CCC-rated securities. 

For now, we would recommend high-yield investors focus on the opportunities at hand. In our strategies, for example, we’re looking to pare bonds that have substantial downside on weaker earnings and that have not performed up to expectations, add bonds in which we have high conviction that have sold off and carry above-market yields, add to shorter duration bonds selling at a discount with a probability of being retired prior to maturity and add to strong companies that are trading at lower dollar prices simply because they were issued when rates were much lower and therefore carry low coupons. Buying strong companies at big discounts is never a bad idea. Maybe they refinance early, maybe they get upgraded to investment grade, maybe they get acquired or maybe they just perform well with minimal probability of default. All good outcomes. Potentially strengthening portfolios before the market turns up is never a bad thing.

Tags Fixed Income . 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.

Past performance is no guarantee of future results.

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.

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

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