High Yield: Four Considerations for the Months Ahead
High yield has faced a multitude of challenges this year, but we believe there is still value on offer across both high yield bonds and loans—including in less conventional places.
Against this backdrop, we have identified four key considerations for high yield investors in the months ahead.
1. High Yield Issuers on Solid Footing
From high inflation and decidedly hawkish central banks, to concerns of a looming recession and escalating geopolitical conflict, the risks facing markets today are prevalent, and unlikely to be resolved anytime soon. As rising interest rates begin to sting in the broader economy and demand softens accordingly, there are questions around how high yield issuers will fare, and to what extent margins may be impacted.
The good news is, many companies are in a stronger financial position coming out of COVID than they would have been pre-COVID. Following the onset of the pandemic, many high yield issuers took advantage of previously healthy capital markets to refinance debt, reducing coupon payments while also extending maturities. Cash flows, in many cases, have returned to or surpassed 2019 levels—which in turn has led to record margins, with many companies still able to pass inflationary pressures through to the consumer. As a result of the strong fundamental backdrop, the percentage of bonds trading at extremely distressed levels (spreads > 1000 bps) has remained relatively contained, at around 7%, especially compared to previous periods of elevated market stress.1 This suggests that a material increase in defaults is unlikely in the near-term.
Also on the positive side, earnings estimates for the remainder of this year and into 2023 have been far more durable than some market participants were expecting, even in the face of negative sentiment. One reason for this is the still-strong nominal growth environment, as revenue and EBITDA are driven in nominal dollars. Thus, even as we head into a difficult economic period, earnings may be able to hold up better than in previous down cycles.
It is also worth noting that unlike equities, high yield does not require strong economic growth to perform well. Rather, what matters most is an issuer’s ability to meet the interest payments on its outstanding debt obligations. And in our view, the combination of strong fundamentals, a low default outlook and potentially more durable earnings puts most high yield issuers in a strong position to meet their obligations going forward.
1. Source: Bank of America. As of August 31, 2022.