The Wind Remains at High Yield's Back (For Now)
Global markets continue to experience strong momentum as vaccinations become more prevalent, businesses re-open and consumers reach deeper into their pockets—and high yield is no exception. Both high yield bonds and loans ended the second quarter in decidedly positive territory. While loans outperformed bonds early on amid lingering U.S. Treasury yield volatility, that trend reversed toward quarter-end as the 10-year stabilized. For the quarter, U.S. high yield bonds led the charge, returning 2.79%, followed by European bonds with 1.60%.1 U.S. and European loans returned 1.44% and 1.35%, respectively.2 Across the board, cyclical sectors like energy led performance after being hit particularly hard by the pandemic and subsequent lockdowns.
Supportive Fundamental and Technical Backdrop
From a fundamental standpoint, high yield appears to be on solid footing. Defaults are low in the U.S. and Europe, and we expect them to fall in line with historical averages of between 2-3% this year, particularly given that distressed ratios are still at multi-year lows. At the same time, company earnings, revenues and cash flows are expected to remain well-supported by the resurgence in consumer demand this year and into 2022. While inflation concerns linger, and were escalated with the Fed’s unexpectedly hawkish turn in June, many companies have so far been able to push prices through to the consumer.
The strong economic backdrop, coupled with improving default expectations, have caused spreads to tighten significantly. However, while bond and loan spreads are currently hovering near post-financial crisis tights, they remain wider than all-time tights and look favorable relative to higher-rated corporates. It is also worth pointing out that the quality of the global high yield bond market is significantly higher today relative to history, with BBs making up nearly 60% of the market, up from 35% in 2007.3 This uptick in quality is due in part to last year’s record fallen angel activity, as a number of large, investment grade-rated companies were downgraded into high yield as the pandemic took hold. In the U.S. market in particular, as much as $200 billion of high yield debt looks likely to migrate back to the investment grade market going forward, which presents opportunities to identify candidates for upgrades.4
With the markets still open, high yield bond issuance has surged to nearly $290 billion in the U.S. and roughly €80 billion in Europe—one of the fastest starts to the year in the last decade (Figure 1). Refinancings have accounted for a large portion of this, with many companies looking to get ahead of potential rate increases down the road. While the heightened capital-raising activity suggests some companies will need to start deleveraging going forward, most proactively managed their maturity profiles leading up to the crisis and will not face impending maturity walls for several years. Balancing the strong supply picture, demand remains steady.
FIGURE 1: ISSUANCE HAS SURGED IN THE U.S. AND EUROPE
Source: S&P LCD. As of May 27, 2021.
The Benefits of Floating Rate
With expectations for continued economic growth coming out of the pandemic, it is reasonable to expect the Fed will at some point move toward tapering and rates will eventually rise. Against this backdrop, there are material benefits to considering variable or floating rate assets such as loans. Because the interest rate on a loan typically resets every three months in line with changes in market interest rates, loans can decrease sensitivity to short-term interest rates—and have historically provided some degree of protection against rising rates in the U.S. and Europe. Loans are also senior in the capital structure, meaning they are paid back ahead of subordinated debt and equity, and secured by some or all of a borrower’s assets, offering further credit protection. A rising rate environment can also be beneficial for collateralized loan obligations (CLOs), which like loans offer floating-rate coupons and therefore can help lower interest rate risk.
That said, high yield bonds, while fixed-rate assets, still look relatively well-positioned in a reflationary environment given their shorter duration relative to other fixed income asset classes. Whereas investment grade corporates have an average duration of over eight years, for instance, high yield bonds have a duration of roughly four.5
Navigating the Months Ahead
While the economy appears to be on a positive trajectory, and companies remain well-supported by ample liquidity, there are plenty of uncertainties on the horizon as we look toward the second half of the year. For one, while developed markets may be through the worst of the pandemic, there are questions as to whether flare-ups in other parts of the world, namely Asia, could threaten corporate supply chains already struggling to meet growing consumer demand. Labor is another question, with companies in both the U.S. and Europe facing shortages as they look to re-build their workforces.
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 higher-yielding bonds and loans on a strategic basis. Given the potential for shorter-term bouts of volatility, we see particular benefits to a multi-credit strategy that invests not only in bonds and loans across the U.S. and Europe, but also in non-traditional segments of the market like CLOs. In addition to offering opportunities to pick up meaningful incremental spread, the flexibility of a multi credit strategy enables managers to pivot to those regions or sub asset classes that offer the most attractive opportunities at any given point in time—and away from those that pose the biggest risks.
1. Source: Bank of America Merrill Lynch. As of June 30, 2021.
2. Source: Credit Suisse. As of June 30, 2021.
3. Source: Bank of America Merrill Lynch. As of May 31, 2021.
4. According to Barings’ internal HY/IG Crossover tracker.
5. Sources: Bloomberg Barclays; Bank of America Merrill Lynch. As of June 30, 2021.