2021 proved to be accommodating for high-yield-rated companies looking to refinance their debt. Many companies were able to lock in lower coupons during the low-rate environment and reduce their interest requirements. Companies that didn’t take advantage of the opportunity are having a tough time accessing the new issue market, given the relative risk aversion that has taken hold. According to Bloomberg, year-to-date (YTD) high yield new issue volume stood at roughly $87 billion, “the lowest since 2008 and down about 78% from 2021.”1
Recession fears have prompted significant outflows from high-yield credit and other risk asset classes. The Federal Reserve (Fed) is committed to its restrictive stance, and “doing whatever it takes” in order to bring inflation down. The era of “cheap financing” is over and companies are starting to feel the heat.
With macroeconomic uncertainties putting a damper on near-record demand for goods and services, companies are starting to adjust to the post-pandemic economy. Some high-yield companies are approaching distressed levels, with deteriorating fundamentals, bloated capital structures and heavy exposure to floating-rate debt.
Why does this all matter? The difficult operating environment, supply chain constraints and pervasive inflation have all led to soaring costs and put downward pressure on margins. Profitability has taken a hit while rates have risen sharply. In the short to medium term, some high-yield companies may be unable to service their debt, which portends a wave of ratings downgrades and potential bankruptcies.
According to Moody’s, downgrades are now outnumbering upgrades and defaults are forecasted to increase from a low of 1.5% through August to 4.4% a year from now.2 Those companies higher up the ratings spectrum (i.e., those with stronger credit metrics) are better insulated from rising rates and macroeconomic shocks. Better liquidity, healthier maturity profiles and exposure to fixed-rate debt may benefit those high-yield companies entering a recession.
Conversely, for those lower-rated issuers, higher rates combined with elevated inflation will limit free cash generation. Higher costs will eat away at profitability and cash flows, and those companies with unsustainable capital structures may be unable to cover the interest on their debt or even pay down upcoming maturities.
This week’s chart highlights the average option-adjusted spread (OAS) for the Bloomberg US Corporate High Yield Index. This gives an indication of the overall credit quality of the high-yield market. To note, spreads will tend to increase during times of weaker macroeconomic conditions. As the chart shows, when the COVID-19 pandemic threw the U.S. economy into a recession, high-yield spreads widened to roughly 1,100 basis points (bps) from roughly 380 bps.
With third-quarter earnings season quickly approaching, I expect to see more companies miss consensus estimates and further downward revisions to guidance. Weaker demand for goods and services will reverse some of the strong earnings growth experienced during 2021 and through the early part of 2022. However, I am still confident in many companies whose management teams have right-sized balance sheets, expanded margins, brought leverage down and improved liquidity. Navigating these times with fundamental research is necessary to find opportunities with a good balance of risk and reward.
Key Takeaway
2021 saw strong corporate earnings, lower rates and high-yield spreads that reached the tightest levels since 1998. These are historic times, as the Fed works to get inflation under control while aiming for a “soft landing.” Shortly after the pandemic began, the influx of fiscal and monetary stimulus that entered the economy led to lower rates and dislocated valuations.
Now, Treasury rates are around 4% and the floating-rate benchmarks are between 3.25% and 4.00%.3 Many companies have not had to contend with such elevated borrowing costs, coupled with strained operating metrics. It will be especially difficult for those companies at the lower end of the ratings spectrum, where there is more exposure to bank debt, greater earnings volatility and where liquidity is weakest.
Index Definition:
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.
Sources:
1Source: Bloomberg- US HY OPEN: Junk Bonds Drop Most in Two Weeks as Investors Balk; 10/13/22
2Source: Moody’s- Leverage Finance Interest; September 2022
3Source: CNBC- U.S. Treasurys; as of 10/10/22
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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