High yield bonds: volatility is opportunity
Adam Darling discusses yield trends in high yield bonds and why credit selection is so important.
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
Source: Bloomberg, Global HY Index: ICE BoFA Global High Yield Constrained Index, as at 29.09.23
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
Source: Bloomberg, Global HY Index: ICE BoFA Global High Yield Constrained Index, as at 29.09.23
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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