Torsten Asmus
By Lydia Hamill, Manager, Fixed Income and Multi-Asset Product and Lena Katsnelson, Senior Manager, Fixed Income and Multi-Asset Product
For fixed income markets, 2022 has been a transformative year, marking the end of 15 years of low interest rates and opening the door to the first global inflationary surge in 40 years. The Federal Reserve’s aggressive moves to bring inflation under control, including a series of rate hikes, have not been kind to fixed income in general, pushing yields higher across the curve. However, some assets have fared better than others.
Earlier in the year, markets saw a number of asset managers positioning for rising interest rates by moving down the yield curve into shorter duration assets, including high-yield. This positioning has largely paid off when the great ‘reset’ took place and interest rates rose sharply. The high-yield sector came out on top of the investment stack from a performance angle. For the first six months of 2022, US high-yield bonds outperformed investment-grade in the US, shown by figure 1. US high-yield bond funds received inflows of $4.8 billion in July, 2022,1 perhaps marking a new high tide for high-yield assets.
As with any tightening cycle, the risks of recession are on the rise. The 2s/10s curve keeps inverting, seen by many as a reliable indicator of a slowdown for the US economy2. It is quite common to see a flight to quality accompanying recessionary fears and high-yield, on the surface at least, seemed like an unusual choice. However, this economic cycle could be very different from anything we have seen in the last 40 years, and it could be informative to look at old assets through a new lens. So, what makes the high-yield sector appealing in this environment?
There are a couple of possible explanations for the growing interest in high-yield bonds. Firstly, the high-yield sector tends to be less interest rate sensitive due to the lower duration. This is structural, as investors are generally averse to lending to lower credit tiers for long terms, and prefer shorter exposures. When compared with other assets, the FTSE US High-yield Market 0+ Index has the lowest effective duration across the US fixed income market.
Moreover, the US high-yield market has shown good spread resilience. The FTSE US High-Yield Market Index has widened to just over 500bps in September 2022, remaining significantly below pandemic highs of 900bps in April 2020 and even below March 2015 highs, peaking as a result of the Federal Reserve tightening. This spread resilience can be further attributed to sector fundamentals, where in contrast to previous economic downturns, the high-yield market is entering the down-turn period from a position of strength.
Strong Balance Sheets
The relative financial strength for US high-yield corporates today versus other periods of market volatility reflects the fortification of balance sheets that we saw during the pandemic. At the time, corporate issuers tapped the debt market and replenished cash reserves. Initially, metrics like leverage ratio and coverage weakened, but as the economy recovered, earnings rose, and balance sheets improved beyond pre-pandemic levels – the ongoing uncertainty as a result of Covid led to companies taking a conservative approach to managing their balance sheets. The deleveraging has been significant, and default rates for the high-yield segment are predicted to be low as a result. Although these are expected to rise, they are rising from historic lows, and interest coverage and leverage ratios are at historic highs3. Moreover, many of the high-yield issuers most at-risk of defaulting have done so during the pandemic, meaning that today, the strongest have survived4.
Pushed Out Maturity Wall: Additionally, balance sheets have been strengthened by pushing out the maturity wall. The high-yield market has gone through a re-financing wave during the low interest rate cycle, with 2021 being a record issuance year for the sector. The recent issuance wave reduced the impetus for high-yield issuers to tap the market at higher rates or engage in refinancing activity, reducing the sector’s exposure to the higher rate environment. According to the FTSE US High-yield Market 0+ Years Index, which tracks the US high-yield market to maturity, only 2.6% of debt is scheduled to mature by 2024, and 7.0% slated for maturity by 2025.
Additionally, while a short-term, US high-yield exposure could be used to hedge somewhat against rising rates, the potential for unintended name concentration needs to be considered. While restricting the FTSE US High-Yield Market 0+ Years Index to a 0-3 year exposure reduces the number of individual issuers by 40%, the biggest issuer weight increases from 3.2% to 4.4%[5]. As flows to short-term instruments increase, the single name exposure across multiple assets can present significant counterparty risk. FTSE Russell calculates a FTSE US High-Yield Market Capped Index, where the total debt of any single issuer is capped at $15 billion of par amount outstanding, to support name diversification.
Higher concentration in ‘BB’ tiers
Another interesting consideration is the credit distribution within the US high-yield universe. Compared to previous downturns, the lowest concentration is in the ‘CCC’ bucket of 10.8% weight, compared to 11.1% weight during the pre-pandemic turbulence of 2019. It is also materially less than the 20% concentration in ‘CCC’ going into the last recession of 2008. In addition to overall reduction in lower credit tiers, there is a higher concentration of quality ‘BB’ assets compared to the previous periods, both generally, and within the early stages of the maturity wall, as shown by figure 4. As result, the high-yield sector today has a much stronger credit profile.
Energy Sector
Over the years, high-yield and energy have become quite intertwined, as the US high-yield market amassed one of the highest exposures to energy sectors amongst the fixed income indices. As of October 2022, the Energy sub-index makes up 13.1% of the FTSE US High-Yield Market Index by market value. There is a strong negative correlation between spread to treasuries for the FTSE US High-Yield Market Energy Index and the price of oil, with the index widening during times of oil price declines. Previous economic downturns have been marked by substantial decreases in oil prices. However, the current situation is very different, with oil prices on the rise due to supply-side disruption, delivering a significant windfall to issuers, and strengthening corporate balance sheets.
So, it looks like the US high-yield sector is well positioned and has good tailwinds heading into the new cycle. However, there are always wild cards in play, and with the Federal Reserve prioritizing inflation, the risk of the Fed tightening too much and too fast is significant. Liquidity could dry up faster than the market anticipates, and the economy could become stressed beyond expected scenarios causing a trend reversal for the corporate market and high-yield. However, under less severe scenarios, US high-yield looks quite appealing.
1 Source: Refinitiv
2 U.S. 2s/10s Treasury yield curve inverts, Reuters
3 Is it time to consider high yield? InsightInvestment, August 2022
4 Three Reasons It’s Time to Add High-Yield Bonds, Alliance Bernstein, July 2022
5 FTSE Russell, as of September 30, 2022.
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