The tightening of high-yield (HY) spreads has emerged as one of the prevailing themes in credit so far this year. More specifically, BB spreads at nearly 20-year tights. According to Bank of America, roughly 40% of the HY market now trades inside of 200 basis points (bps), which has historically been dominated by investment grade (IG) corporates.1 I believe the relative lack of HY new issuance has been contributing to this dynamic. Year-to-date (YTD) issuance for HY bonds and leveraged loans is up 96.3% and 298.2%,2 respectively. However, this comes off of a low base in 2023, where issuance was limited due to tighter credit conditions. Expectations for Federal Reserve rate cuts and easing monetary conditions led to a busy syndication calendar early in 2024, with loan repricing activity picking up as levered companies took advantage of a relief in rates to address floating-rate debt. In my opinion, the imbalance between the demand for “yield-ier” HY corporates and the relatively thin supply is contributing to tighter spreads.
This imbalance has created a slippery slope as investors, hungry for yield, have looked farther down the quality spectrum to satisfy their appetite. Over the course of 2023, CCC-rated bonds outperformed both single-Bs and BBs, returning +5.9%, +3.6% and +3.2%, respectively.3 CCCs have also outpaced the broader HY index by roughly 50 bps YTD.4 Many of these companies performed well over the same time period and prudently managed their capital structures. Those with solid operating performance and liquidity were greeted with access to the primary market. Interestingly, CCCs outperformed in a year where the most commonly used word to describe the earnings environment seemed to be “normalization.” Demand for certain products stagnated, and prices rolled over. For most of my coverage, margin expansion largely underwhelmed and guidance was limited. For those distressed issuers where performance was poor and liquidity was weak, liability management exercises (LME) became more common toward the end of 2023 and during the early part of 2024. This theme was examined in last week’s Chart of the Week by Greg Zappin. Certain issuers with looming near-term maturities or overleveraged capital structures have taken part in a variety of exercises to avoid bankruptcy restructuring. Investors have become wary of these events and seemingly shifted their focus up the quality spectrum, favoring companies with stronger credit metrics and liquidity. This shift was evident in the relative underperformance of CCCs for the majority of April; month-to-date (MTD) returns for the CCC bucket were -0.90% compared to -0.78% for the broader HY index as of April 30.5
I believe the more pressing issue, at least concerning the primary market, is the imbalance between the supply of new HY debt and the demand. The stronger demand for yield could lead to lower-quality issuers gaining access to the primary market, looser covenants and tighter pricing for deals. Investors who accept those looser covenants will pave the way for more liability management events should those issuers struggle down the road. Given this prevailing dynamic in HY, I think it’s more important now than ever to selectively add risk. We won’t compromise on covenants, but we have done well picking the right situations with CCCs and certain distressed issuers.
Key Takeaway
Despite the strong year-over-year (YoY) issuance statistics for HY debt, there is still an imbalance between the demand for greater yields and the supply of new bonds. In part, this relationship has seemed to keep spreads near all-time tights. I think we’ll see more new issuance cross the finish line, that otherwise would have priced much wider or with much tighter covenants. Investors who accept looser covenants on any upcoming bond deals could effectively give management teams latitude to be more aggressive should their companies face trouble in the future. We are seeing these situations occur now, as liability management has become the dominating theme in distressed credit.
Sources:
1,2Bank of America
3-5Bloomberg
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