The high yield market is in an odd position. On the one hand, there are clear and mounting signs of corporate distress – bankruptcies and defaults are rising and many companies are feeling the pain of rising borrowing costs.
Yet it continues to go from strength to strength – spreads over government bonds continue to narrow and money continues to flow into the sector. What explains this apparent discrepancy?
There are emerging signs of problems for highly indebted corporates. In the UK, government data showed company insolvencies in England and Wales rising 40% year on year, with 2,552 companies declared insolvent in May.
Eurostat reports that the number of bankruptcy declarations among EU businesses is running at its highest level since the start of data collection in 2015, rising in all four quarters of 2022.
There were 18 debt defaults in the US loan market in the year to the end of May, totalling $21bn, according to Goldman Sachs analysis. This is higher than for the whole of 2021 and 2022 combined. S&P Global reports that more than 230 companies have filed for bankruptcy in 2023, saying that most have a common theme – unsustainable debt, coupled with a deterioration in operational quality.
Yet, it has been a relatively buoyant start to the year for high yield bonds. The average sterling high yield fund has returned 4.2%, outpacing higher grade corporate and government bonds. The same is true for the global high yield bond sector.
The spread over government bonds (as measured by the ICE BofA US High Yield Index Option-Adjusted Spread) is currently 4.2%. That compares to 10.9% at the height of the pandemic, 5.9% a year ago, and as high as 19.9% at the height of the global financial crisis.
Partly, this is a response to recent poor performance. Funds in the sterling high yield sector dropped by an average of 10.2% in the calendar year 2022, though again, it is worth noting that this was a smaller drop than for higher quality corporate and government bonds.
In general, a period of weak performance has usually indicated a good buying opportunity. Fisch Asset Management says the asset class has never suffered two negative years in succession.
Another reason may be the shrinkage in the market. Ninety-One points out that the US high yield market has contracted by 11% since its peak in December 2021. This is unprecedented and comes as a result of paltry new issuance in 2022 and 2023 – those that could refinance have done so at lower rates and are not tempted to do so now with rates far higher.
Ninety-One says: “Significant contractions in market size such as this often act as very supportive technical tailwinds to credit spreads/prices, as investors have a smaller pool of assets to invest in.
“In our opinion, this is one of the key factors that has supported high yield credit spreads for the year to date, reflected in this part of the credit market behaving remarkably well in the face of a variety of negative headlines surrounding a potential looming recession.
“The phenomenon of asset class shrinkage can be a powerful and supportive forced for extended periods of time.” However, it says caution is required and that “the tide will eventually turn and these technical dynamics can unravel very quickly.”
While absolute yields are still well-supported by high interest rates, with little sign of any short-term reversal, spreads could come under pressure if credit quality deteriorates. For the time being, companies have not had to come back to market, but companies will have to refinance at some point and investors will have to be agile enough to act before the market starts to reflect weakness.
Many multi-asset investors are still nervous on the asset class, believing investors are not sufficiently compensated for the looming risks. Paul Flood, head of mixed asset investment at Newton, says: “We’re not being paid enough for the risk inherent in the high yield bond market.
“Certainly, these bonds have a high yield, at 8-9%, but the right discussion should be what is being received over government bonds. That is just 400-500bps. At the peak of the last debt debacle in the US, this was 800-900bps over government bonds.
“People are just looking at the yield rather than the spread over government bonds. They need to consider what they are being paid for lending to corporates.” Flood’s view is that investors need to be very stock specific if they are going to invest in the asset class.
Luca Paolini, chief strategist, Pictet Asset Management believes there is more value in Eurozone high yield debt than for the US. He adds that US high yield debt is coming under pressure from the regional banking crisis and tightening lending conditions. The sector may also face challenges from a tighter regulatory environment, with the Fed poised to present new capital rules in the coming months.
He also sees low demand for credit: “Demand for commercial and industrial loans stood at historically low level of -53.3 per cent on a net basis while that for commercial real estate, for example, has hit an all-time low.”
Fisch also believes there is more value in the European high yield market, saying it offers investors a higher spread than their US peers for the same rating. The euro high yield market may also prove more defensive overall because of its higher average rating and lower duration.
The high yield market continues to defy gravity, but this is unlikely to endure in the face of greater corporate distress. The technical support for the market may keep it afloat for a while, and the impact of higher borrowing costs will hit the market relatively slowly, but cannot be deferred indefinitely.
While yields may look superficially attractive, it is the moment to be with the strongest credit manager available.
