High Yield: Still Strong, Despite Market Jitters
The story of 2021 has been one of strong economic recovery, although sentiment has waned somewhat amid uncertainty surrounding the spreading Delta variant, U.S. Federal Reserve (Fed) tapering, and headlines out of China. Nonetheless, both high yield bonds and loans ended the third quarter in modestly positive territory. For the quarter, European loans returned 1.14%, slightly outperforming U.S. loans, which returned 1.13%. U.S. and European high yield bonds returned 0.93% and 0.83%, respectively.1
A Bright Outlook
The high yield market continues to benefit from a strong fundamental and technical picture. Corporate earnings are solid, default rates are low, and many companies, so far, have had the pricing power to pass inflationary pressures through to their customers. On the technical side, new issuance continues at a record pace in both the U.S. and Europe, as many companies look to reprice the debt they raised last year at more attractive levels. Overall, the market has been largely receptive to that, both with fixed and variable rate debt—an indication that the market is listening to central bankers’ message that inflation, for now, is only transitory. Although the Fed has given no indication that it will raise interest rates this year, it may begin tightening monetary policy as it starts to taper its asset-purchase program. Even with the tapering, however, its purchases are still at a volume that will continue to add significant liquidity to the system.
Since the start of the second quarter, we have seen a notable increase in merger & acquisition (M&A) activity, and leveraged buyout activity in particular. This represents a shift from last year, when private equity sponsors expended a significant amount of dry powder helping portfolio companies manage the impact of the pandemic. With the recovery underway, we expect the increased focus on M&A to continue through the end of the year, which should help keep the pace of new issuance in the high yield market strong.
Still, cracks are appearing at the edges of this positive outlook. Globally, the sporadic lockdowns in China, spikes in fuel prices and other factors are disrupting the normal supply-chain dynamics for companies, and businesses are experiencing shortages in products ranging from groceries to microchips. Additionally, given the spread of the Delta variant, it now appears that the companies most affected by COVID—like those in the travel and entertainment sectors—may see some degree of disruption into 2022. Still, most are open and operating, even if only at 50% to 60% of their pre-COVID capacity.
The market turbulence that erupted when it appeared that Chinese real estate developer Evergrande could possibly default on its debt is an indication of how jittery investors have become. In our view, the circumstances with Evergrande are very much a China event, unlikely to significantly impact the U.S. and European markets. We believe the reaction stemmed more from the fact that the equity market is at record highs and, as often happens in such circumstances, investors seem to be looking for an event that might bring a correction. That said, an equity market correction, and investors’ anticipation of it, may ultimately help the high yield market. If investors trim equity positions, high yield bonds and loans may stand to receive a significant portion of those reallocations. Even though high yield spreads are tight, we think there is still value in the market, particularly given its higher quality relative to history. In the global high yield bond market, for instance, almost 60% of bonds are BB-rated, up from about 35% a decade ago (Figure 1).
FIGURE 1: THE QUALITY OF THE HIGH YIELD MARKET IS HIGHER TODAY RELATIVE TO HISTORY
Source: ICE Bank of America. As of September 30, 2021.
Key Areas of Opportunity
In an environment of heightened uncertainty, and with bouts of volatility likely to continue, it is important to analyze companies on a case-by-case basis to determine which ones have the liquidity and balance sheet flexibility to handle any continued disruption. That said, as we look across the high yield market today, we are seeing opportunities in three key areas:
In 2020, roughly $200 billion worth of investment grade debt was downgraded to high yield, including some big and high-quality companies like Ford and Occidental Petroleum. With the economic recovery underway, we are now on the other side of this development. While some companies have already made the move back investment grade, a number of others look poised for an upgrade over the next six to 12 months. Of note, this rotation from downgrades to upgrades is not only occurring across the investment grade line, but also between CCC and single-B debt. Given the restrictions on who can own CCC debt, those upgrades should also bring considerable benefits for companies.
FIGURE 2: VOLUME OF FALLEN ANGEL/RISING STAR ACTIVITY
Source: J.P. Morgan. As of September 30, 2021.
Senior Secured Bonds
The senior secured bond market experienced substantial growth last year despite the COVID-related disruptions to business—due largely to its emergence as a viable source of funding for companies when other capital-raising avenues, such as loans and unsecured bonds, faced limitations. This growth has resulted in an attractive and diverse opportunity set for investors, particular given the capital structure seniority and security of the bonds. Senior secured bonds also tend to be shorter in duration relative to other, longer-duration fixed income asset classes, which can provide a degree of protection against interest rate moves when they do occur.
CLOs, EM Corporate Debt
Given the potential for tapering, as well as the likelihood of short-term bouts of volatility going forward, we also see opportunities in non-traditional segments of the market like collateralized loan obligations (CLOs) and emerging markets corporate debt. In the CLO market, for instance, heavy supply around quarterly payment dates has led to predictable periods of spread widening, creating attractive relative value opportunities. CLOs can also help lower interest rate risk, given their floating rate coupons. EM corporate debt is another area worth considering—recently, bouts of volatility in countries like China and Turkey have caused corporate spreads to widen beyond what fundamentals would suggest, creating opportunities to identify solid issuers at attractive prices.
As we look ahead to the coming months, and with many investors still facing challenges when it comes to meeting their yield targets, we expect to see continued demand for high yield bonds and loans on a strategic basis. Amid concerns that the Delta variant and other factors could dampen economic growth, it is also worth noting that high yield, unlike equities, does not require strong economic growth to perform well. Rather, what matters most in high yield is an issuer’s ability to continue to meet the interest payments on its outstanding debt obligations. And in our view, much of the recent market concern overlooks the fact that many high yield companies today have healthy balance sheets and remain supported by ample liquidity.
1. Source: ICE Bank of America, Credit Suisse. As of September 30, 2021.