Everything is gung-ho about the high yield bond markets now. At least that’s the impression one would get if you go by credit spreads. The premium that investors demand to hold lower-rated notes instead of government bonds is at multi-year tights, indicating that investors are pricing in the best outcomes for the economy as well as the asset class.

Investors are encouraged by the fact that the performance of the asset class over the past year has far exceeded even the most bullish predictions. Despite aggressive interest rate increases, the global economy has so far warded off a recession. In the US, the largest market for such bonds, the economy has been able to withstand higher rates, thanks to a boost in household savings during Covid, fiscal stimulus and a strong labour market.

CREDIT SPREADS DEFY ANY SIGNS OF NERVOUSNESS 

Valuations in perspective

Source: Bloomberg Global HY Index: ICE BoFA Global High Yield Constrained Index, as at 29.02.24

With inflation slowing in most developed economies, central banks are gearing up to cut rates. The dovish outlook is considered a sweet spot for the high yield bonds, which are generally more volatile than their higher rated peers. A soft landing is now the consensus. Investors believe that central banks could guide their economies forward with minimal disruption to growth or jobs. That’s reflected in the euphoric pricing of equities and crypto markets as well.

However, bond buyers have chosen to ignore the many risks that could upend this optimistic outlook. We have repeatedly flagged how a plethora of companies will face the daunting task of refinancing their debts as they mature over the next three years. With higher interest rates sharply pushing up the market yields of bonds across the board, companies will be forced to pay much higher coupons than what they are paying on their existing debt. This could severely strain their finances.

COMPANIES FACE A REFINANCING HUMP AHEAD

Global high yield maturity wall

Source: Jupiter, Bloomberg, as at 29.02.24.
Maturity wall is computed considering non-IG corporate bonds (as per Bloomberg composite rating) denominated in DM currencies, excluding perpetual securities.
It’s true that many high yield companies have successfully raised funds this year, and that has to some extent brought down the overall refinancing requirement. However, refinancing to date has primarily involved only those companies best placed to pay a higher cost of debt: companies with solid operating profiles and reasonable balance sheets.

The lowest-quality part of the market is still struggling to refinance, and the risk is getting increasingly concentrated as time passes. Companies with operational problems or over-levered balance sheets, used to the forgiving conditions of a multi-year credit bull market, face severe challenges. It’s worth bearing in mind that the European market hasn’t seen any new `CCC-rated’ bond deals for almost two years. Any marginal cut in policy rates by central banks wouldn’t be of much help as the finances of these companies are engineered to work only in the zero-interest rate environment that had existed for many years after the global financial crisis. In the foreseeable future, we expect many companies to restructure or default on their debt.

In contrast to the euphoria seen in markets, the real economy has been showing some signs of stress, and that could worsen further as the lagged effect of interest rate increases kick in. Corporate bankruptcies and loan defaults are already spiking. While the US Federal Reserve and other major central banks have signalled some rate cuts this year, we haven’t seen any easing so far. Markets are dialling back their expectations of 2024 rate cuts as economic growth and inflation continue to hold up more than expected. The “higher for longer” interest rate environment puts stress on all borrowers and eats into the refinancing window for weaker companies.

On the macroeconomic and political front as well, many things could go wrong. Many important countries, including the US, are preparing for elections later this year. Geopolitical uncertainties abound too, with the ongoing Russia-Ukraine and Israel-Hamas conflicts, as well as simmering tensions between the US and China.
DELINQUENCY RATES ON CONSUMER CREDIT HAVE BEEN INCREASING

Credit card debt – delinquency rate                  

Source: Bloomberg, as at 31.03.24

Auto loans – delinquency rate             

Source: Bloomberg, as at 31.03.24
Despite these risks, the high yield market is not pricing in any bad news at all. The US high yield market is the most expensive since the global financial crisis. All this means we should brace for a highly volatile environment ahead if the bullish assumptions made by investors come unstuck.

However, this doesn’t mean active asset managers can’t generate returns in this environment. The yields on offer in the market are still very attractive from a historical context, and the strong performance of the asset class over the last 12 months highlights how the higher yield environment creates good opportunities. Careful credit selection based on a thorough assessment of fundamentals of every company that one invests in is crucial. Considering the market backdrop, staying relatively agnostic on ratings, sectors or geography, and carefully evaluating each investment on a case-by-case basis, would stand active asset managers in good stead.

We believe it’s too early to say whether a soft landing could be achieved. In any case, for the high yield market, the soft-landing no longer provides further fuel for the rally – it is already fully priced into credit spreads. Credit spreads tend to mean revert over a period of time and we could see some widening ahead if the soft-landing narrative stalls. It’s important to be patient in this environment.  We’ll know a lot more about the real impact of the “long and variable lags” of monetary policy after the world has finished refinancing into these higher interest rates and is actually paying them. The clock is ticking.

The value of active minds: independent thinking

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