US High Yield Market Update

US High Yield Market Update¹

• February saw all asset classes reprice lower with high yield corporates outperforming.
• High yield flows are -$9.4 billion YTD with nearly -$6.0 billion of that coming in the final two weeks of February.  The majority of the flows were from ETFs and passive strategies.  There was negligible effect on secondary trading liquidity because while ETFs will at times be large volume drivers, they remain a small part of overall AUM and have minimal effect on market making activity.
• Overall trading volumes are slightly higher year-on-year with activity primarily revolving around new issue and ETF rebalancing. Any perceived weakness continues to be met with significant buyer demand amongst the traditional high yield investor community. 
• The primary market has priced approximately $34 billion notional to date with issuers using moments of market strength for any refinancing needs.  We have also seen some successful syndication of M&A financing as well as placement of debt previously warehoused on bank balance sheets.  Limited net new issuance continues to provide a strong tailwind for high yield.
• High yield has experienced a reversal of the decompression trade which was relevant for almost all of 2022 as lower quality credit has rallied significantly.  There is strong demand for CCC credits with no obvious near-term default risk.   
• Earnings have been largely in line thus any larger credit moves have been due to idiosyncratic risk versus exogenous macro variables.
• Federal Reserve policy meetings and subsequent rate decisions remain a key focus for credit markets as do economic indicators tied to inflationary trends and employment data.

Below are the three key focus areas for investors to consider:

1) Improved entry-point with higher yields and lower FX hedging costs

The weakness experienced in several markets during February, inclusive of US High Yield (US HY), is giving investors another chance to increase exposure to this higher yielding asset class.  The US HY market yield to worst (YTW) ended the month at 8.65%, above the recent low of 7.98% in mid-January.  This recent increase in yield has largely come from the rise of risk-free rates as investors reconsidered the health of the US economy, inflation expectations and expected Fed policy.  Spreads have remained in the low 400s range, which can also be attributed in part to an improved outlook on the US economy. 

Although the high yield market YTW has not quite returned to the highs of 9.61% in October 2022, for some investors the return outlook is better today after considering the cost of hedging.  For example, the cost of hedging for European investors has dropped over 100bps over the past three months.  Yield is just one component of future expected return and hence investors should consider their own return expectation when making relative investment allocation decisions, however current YTW and annualised hedge costs suggest an improved return outlook for European-based investors and improved relative value of the US HY market for all global investors.   

2) Shifting sentiment towards lower-rated securities 

There has been a notable shift in sentiment in 2023 compared to the 4th quarter of 2022.  Several market participants have begun to highlight the attractive relative value of the higher yielding, lower rated segment of the HY market, but with caveats.  This differs from the many 2023 outlooks, produced in 2022, that called for higher quality credit ratings to outperform.  Market calls for a “Bearish Compression” (rate driven sell-off where CCC outperforms, like February) often highlight the attractiveness of a portion of the market that can go by several names such as “performing CCC”, “CCC ex-distressed, “higher quality CCC”.  We consider “higher quality CCC” to be defined as companies that are experiencing strong results operationally, but may have higher leverage in the eyes of the credit rating agencies. We believe that a selective and concentrated approach to CCC securities can remove significant credit risk while still benefiting from the yield advantage of this portion of the market.

3) Inflation and the outlook for the overall economy will remain the primary narrative for markets, but industry-specific earnings underperformance is worth monitoring

Similar to 2022, we continue to make investment decisions with the expectation of a mild recession over the next 12 months.  However, for individual issuers, we believe a mild recession is not the only economic scenario that warrants concern.  We are also cautious on an economic environment where the overall economy is performing well, but there are specific sectors or issuers experiencing recessionary headwinds on cashflows.  In this environment, rates could remain high due to the health of the overall economy, and levered issuers with floating rate interest exposure operating in these weaker sectors will experience an increase in their default risk as their cashflow to interest coverage ratio declines rapidly.  These are the situations that we are closely monitoring in determining default rate expectations.

Our call for continued high dispersion, particularly within the lower rated segment of the market, is supported by points two and three.  In our view, this environment can reward careful security selection and active management when investing in the US HY market.