High Yield: Strong Tailwinds, But It May be a Bumpy Ride
News of the COVID vaccine transformed high yield’s third-quarter asset price rebound into a fourth-quarter risk rally. Across both the U.S. and European high yield markets, lower-rated B credits outperformed BBs following the vaccine news, while CCC names were also able to retrace a notable amount of their selloff. Likewise, companies in sectors that were more directly impacted by COVID-related disruptions—such as aerospace, travel/leisure, gaming and entertainment—experienced a rebound.
Looking at performance for the quarter, U.S. high yield bonds and loans returned 6.47% and 3.64%, respectively. The European market also ended the quarter in positive territory, with bonds at 5.97% and loans at 3.92%.1 The positive fourth-quarter performance helped push high yield into positive territory for the year, a notable milestone given the steep and widespread decline at the onset of the pandemic. Spreads, too, have retraced much ground (Figure 1).
FIGURE 1: PERFORMANCE U.S. AND EUROPEAN SPREADS (HIGH YIELD BONDS VS. LOANS)
Source: BAML, Credit Suisse. As of December 31, 2020.
While the strong rebound across high yield has led valuations to return to more normalized levels, it is worth noting that high yield asset classes have come back less than equities—where some markets reached all-time highs at year-end—and investment grade corporate credit, which has benefitted from lower interest rates as well as a post-pandemic flight to quality. Further, while spreads tightened over the course of the year, they are still trading wider than they were a year ago—particularly sectors that have been more negatively impacted by COVID. This suggests that there is still upside potential in high yield going forward, particularly given investors’ continued search for yield amid low rates and the rise in negative-yielding debt around the globe.
Liquidity and Leverage
Across the high yield universe, most companies have been able to successfully raise capital on the back of ongoing and substantial central bank support—even those in harder-hit sectors like gaming, travel and leisure. As investors remained willing to capitalize these businesses, high yield bond issuance in 2020 reached a significant $441 billion in the U.S. and €85 billion in Europe, compared to $274 billion and €74 billion in 2019.2 This suggests that most companies have sufficient liquidity to manage any near-term bumps in the road—whether coming from further lockdowns, uncertainty around the deployment of the vaccine or macro/political factors.
As a result of the strong liquidity picture, we believe defaults should be manageable this year, and may be below what we saw in 2020, which was somewhat moderate compared to initial expectations. This view is further supported by the improving credit quality of the market, helped in the last year by a number of investment grade-rated names—many of which are large, well-diversified companies—being downgraded into high yield. In the U.S., for instance, roughly 57% of the high yield bond market is rated BB, versus 38% in 2007, and less than 12% of the market is rated CCC.3
That said, while the debt companies have accumulated has been critical to helping them manage costs and cash flows during the pandemic, current debt levels are likely unsustainable longer-term. Over the next several years, we therefore expect companies will need to begin deleveraging—the pace of which may be dictated by impending maturity walls (Figure 2). While some companies look well-positioned to manage higher debt levels going forward—and indeed with high levels of refinancing activity at the start of the year—others may face greater difficulties, which could impact the default picture down the road.
FIGURE 2: GLOBAL HIGH YIELD BONDS AND LOANS MATURITY WALL
Source: BAML U.S. Non-Financial High Yield Constrained Index (HCNF), BAML European Currency Non-Financial High Yield Constrained Index (HPID), Credit Suisse Leveraged Loan Index, Credit Suisse Western European Leveraged Loan Index Non-$US-Denominated Loans. Bars represents the percentage of aggregate par amount of high yield bonds and loans. BAML indices exclude bonds maturing in less than one year. As of December 31, 2020.
Identifying Areas of Value
Given the substantial liquidity support from central bankers, coupled with a potential economic recovery as a result of the vaccine, it is possible that expectations for short-term rates—and even long-absent inflation may start to rise. While we do not necessarily view this as a 2021 event, if and when inflation and interest rates begin to move higher, there could be benefits to considering variable or floating rate assets such as loans and collateralized loan obligations (CLOs). High yield bonds, which are shorter duration relative to many other fixed income assets, also look relatively well-positioned in this environment.
Loans also represent a potentially compelling opportunity in and of themselves, in our view. Since the onset of the pandemic, a combination of technical factors has slowed the recovery of the loan asset class relative to high yield. As a result, we believe loans currently offer compelling relative and absolute value and could also experience a technical tailwind going forward as demand continues to return. Current spreads on loans also appear to be fairly compensating investors in the context of defaults, which as mentioned above have remained more manageable than originally forecast.
Emerging markets represent another interesting opportunity. Despite the cautious optimism around an economic recovery in developed markets, rapid GDP growth still looks unlikely. By contrast, growth expectations for emerging markets (EM) are likely to be higher—particularly in Asia, where many regions have managed the crisis relatively well and suffered less disruption from lockdowns. It is also worth noting that EM corporates were among the best performers in 2020 and could be well-positioned coming out of the crisis—potentially offering exposure to growth in a world with a limited amount of it.
While high yield markets have bounced back significantly since the troughs of the pandemic, we believe the market continues to offer upside potential, particularly in today’s low-rate and low-yielding environment. That said, there are a number of unknowns on the horizon—from contentious political backdrops to the practicalities of vaccine deployment around the world. As we look out over the next several months, credit selection will be critical to identifying resilient issuers that can withstand short-term volatility and potentially offer attractive upside as the economy continues on what may very well be an uneven road to recovery.
1. Source: BAML; Credit Suisse. As of December 31, 2020. Returns are hedged to USD.
2. Source: S&P LCD. As of December 31, 2020.
3. Based on Barings’ market observations. As of December 31, 2020.