Credit spreads, the additional yield that investors demand to buy or hold high yield bonds compared to government bonds, are still relatively tight even after aggressive rate increases by major central banks since early last year. Investors are complacent about the impact of high rates on the economy, which typically takes effect with a lag. Many investors seem to believe that policy makers can steer the economy towards a “soft landing’’, where inflation is brought within desired levels without losing steam on the growth front. I believe that could prove to be a fallacy. There are many signs that growth is already faltering around the world. Recession concerns dominate Europe and the UK, while China has found it difficult to find its feet after its extended Covid lockdowns. Commodity prices have softened, with the exception of oil. Companies are also turning increasingly cautious on their outlooks and consumer confidence is deteriorating amidst toughening financial conditions and a cooling labour market.

In our view, the global economy is potentially staring at a recession. The stress created by high interest rates is already evident in various sectors. The real estate market is collapsing globally (highlighted by looming Evergrande and Country Garden insolvencies in China), corporate bankruptcies are spiking and a lot of issuers in the high yield market can’t survive with yields at current levels.

Yield to maturity in perspective

Historical yield to maturity and coupon, last 10 years
high Yield graph
Source: Bloomberg, Global HY Index: ICE BoFA Global High Yield Constrained Index, as at 29.09.23 
The chart above illustrates the conundrum facing companies right now. Unless the prevailing yield in the high yield market (“Global HY – YTM” in chart) collapses towards the average cost of what companies have actually been paying over the last decade (“Global HY – Coupon” in chart) a lot of companies could crumble as they get hit with a significant leap in funding costs.

In this environment, companies with strong metrics and the ability to withstand the high cost of refinancing will survive even if that’s achieved at the cost of curtailing capital expenditure or paring back dividends. However, a lot of companies that have over leveraged when interest rates were very low will be in trouble. Such companies could be forced to restructure or may default with some forced to dispose of their businesses to pay down debt. This makes bottom-up credit selection all the more important.

Once a sharp economic downturn begins, credit spreads will have to widen. Currently, the spreads show that market participants have bought into the “soft landing’’ narrative. Technicals have also been quite supportive as high yield bond supply has shrunk between 10% to 20% over the past 12 months. The high yield on offer too has underpinned robust demand. However, I believe the next 6-9 months will be volatile as a looming recession could create havoc in the market.

The chart below shows how the average maturity of high yields bonds has shrunk as companies put off refinancing on the hope that yields may decline. This exercise in “kicking the can down the road” can only last so long, and a looming maturity wall in 2025/26 will test the balance sheets of many companies.

Historical average maturity

As companies waited for refinancing average maturity has sharply decreased
Yield Graph
Source: Bloomberg, Global HY Index: ICE BoFA Global High Yield Constrained Index, as at 29.09.23 
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Any disruption in the market should create great opportunities for active strategies such as ours, and we are approaching the unfolding scenario in a tactical manner.

The bullish case for the asset class is that the yield on offer is very high – historically, future total returns from yield levels that we see today have been positive (often strongly so). But the ability to generate alpha and harvest these returns will depend on managing a volatile credit cycle over the next 12 – 18 months. In this environment, we are happy to remain patient to see what happens next. While getting the macro call is important, rigorous credit research is key in this environment. Selecting the right bonds is important in this market and we believe our fundamentals-driven credit analysis process and our overall philosophy of staying “active, pragmatic and risk aware’’ will stand us in good stead in the coming months.
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