Tighter for longer? The prospects for high yield

April 9, 2024

In our latest Q&A, Bryan Peterman and Thomas Samson share their thoughts on whether US and European high yield is expensive and the opportunities and risks of the looming maturity wall facing issuers.

The global high-yield market has been one of the prime beneficiaries of the compression trade that has characterised credit markets in recent months. If the ‘dash to cash‘ was the big story in 2023, there has been at least a partial reversal of that trend so far this year, with over US$22 billion of net inflows into corporate bond funds as investors search for yield.¹

This increase in demand has come at a time when the high-yield market continues to shrink. Since peaking at over US$2.7 trillion in July 2021, the global market has fallen almost 20% to around $2.2 trillion, as Figure 1 illustrates.

The supply-demand imbalance has created a supportive technical picture for the asset class, helping push credit spreads down from 420 basis points (bps) at the start of the year to around 350bps at the end of March (see Figure 2).

That is some way below its ten-year average of over 470bps. But, as Muzinich portfolio managers Bryan Peterman (BP) and Thomas Samson (TS) explain, when it comes to high yield, averages can be misleading.

Some commentators argue high yield currently looks expensive. What’s your take?

BP: We often get asked about spreads in relationship to averages, but this doesn’t tell you anything because the market rarely, if ever, trades at the average spread. History shows spreads often trade tighter than the average with random major events such as the 2020 COVID-19 crisis causing spikes.

The more relevant questions are what might cause spreads to move tighter or wider, and does the yield compensate you for the risk? We are in the high-yield business, not the high-spread business. And today, that yield is meaningful.

“We are in the high-yield business, not the high-spread business.”

Bryan Petermann

As far as the US goes, there is a good argument that spreads are reasonable on the basis we have a growing economy, liquidity in the market, and declining stress and default expectations. It is also possible spreads could stay around these levels for a protracted period – which is what we have seen in the past  – until there's another event that pushes spreads wider.

TS: By definition, averages capture periods of stability and periods of stress. In the past five years in Europe, we have experienced COVID-19 and the Ukraine-Russia conflict, which caused spreads to blow out. But when we look over the last twenty years, European high-yield spreads have been tighter than their current levels approximately a third of the time.

You also need to consider many high-yield issuers will refinance one or two years before maturity. The ‘pull-to-par’ effect of this equates to an estimated 50bps of additional spread. When adjusting for this, European high yield has been tighter than now approximately half of the time (see Figure 3).

A lot of attention is focused on the high-yield maturity wall. What are the risks and opportunities in terms of refinancing the wall?

TS: This is more of a European issue because US high-yield borrowers tend to issue much longer-dated paper. In Europe, there is a lot of paper due to be refinanced in 2025 and 2026, which we feel will lead to opportunities because of that pull-to-par effect. In the past couple of weeks, we have seen a few bonds with 2026 maturities refinanced at par, which led to an immediate capital gain of two to three points. I believe we’ll see more of this activity in the coming months. A lot of companies are prudent with their balance sheets and will look to refinance early. While they’ll be printing new bonds with a higher coupon, they want that certainty of extending their maturity profiles to 2030 and beyond.

“Refinancings will lead to opportunities because of the pull-to-par effect.”

Thomas Samson

But there is also a small minority who will find this trickier to navigate because they have a number of bonds maturing each year over the next three to four years. This is less of a sector issue and more ratings specific, particularly affecting highly levered businesses at the lower quality end of the market. We’ve seen this in telecoms, real estate and even financial services. Their management teams are not going to find it straightforward to refinance because the maths don’t work.

BP:  A year ago, everyone was talking about the maturity wall in the US with over US$840 billion of high yield and leverage loan debt due to mature between 2024 and 2026. According to Bank of America research, since then issuers have taken out or refinanced US$329 billion, or 40%, of those maturities.² It’s one of the three largest refinancing periods on record. The maturity wall is being knocked down aggressively by mid-single B and double-B issuers and we would estimate refinancings make up around 85-90% of new issuance. As Thomas alluded to, the problems are in the lower-quality triple-C segment and that’s where we may see some predatory behaviour.

There has been much debate about whether consumer spending is running out of steam due to inflationary pressures and higher rates. Are you seeing evidence of this and what are the implications for the high-yield market?

BP: The good news is that inflation has come down from the elevated levels we had in 2021-22, but it is maybe not falling as quickly as everyone would like. You see the effects of that every day, whether it’s in the grocery store or going out to dinner. But over the past six to nine months, we have seen wage growth start to increase in the US to the point where it is catching up with, and in some parts exceeding, inflation. On top of that, unemployment is relatively low, so we have an environment that is allowing overall spending to continue.

When analysing consumer spending, it makes sense to look at what is happening in different income groups. Lower-income households are feeling a lot of pain, and the effect of this will be seen in spending on everyday basic goods. But at the mid-to-high end, we have seen a sizable wealth effect over the past couple of years with real estate prices going up, equity markets reaching record levels, and savers earning more on their fixed income investments due to higher interest rates. So, consumers in this income bracket are doing pretty well and they’re the ones driving the economy right now.

Are there any sector developments you would highlight?

BP: One sector that has done very well recently is travel and leisure. Pre-COVID, this was not a large part of the high-yield universe, but when the pandemic hit, we saw a lot of fallen angels in the sector coming from the investment-grade market. And, as everything reopened, names in those sectors started to do better, clawing back some of the losses they took when everything was closed. This is looking to be a very strong year in areas like cruise lines, which are reporting record bookings even though prices have risen significantly.³

Travel and leisure has become a much larger sector for us. We expect some fallen angels will go back to investment grade, which should offer the potential for spread tightening.

Other parts of the market are experiencing structural changes, which is causing dislocation on the credit side. A good example is cable, telecommunications and media, with disruption in terms of streaming and how people get their broadband.⁴ We’ve seen convergence in that segment, and the winners and losers can’t necessarily be determined yet. So, that’s an area we want less exposure to than we might have historically.

“In real estate, we have seen bifurcation between the haves and have nots.”

Thomas Samson

TS:  Real estate is another interesting area, where we have seen clear bifurcation between the haves and have nots. At one end, you have companies cut off from the bond market because the price they would have pay to issue wouldn’t make any sense in terms of their business model. While their assets are experiencing some level of repricing, the repricing in their cost of funding is more dramatic.

At the same time, we see opportunities at the higher-quality end of the real estate market, including in names that are investment-grade rated and have yields that are comparable to, and in some cases higher than, high-yield corporate bonds in other sectors.

The global high yield market has shrunk by around 20% since its peak in 2021. Is this theme causing any distortion? 

TS: In terms of the US and Europe, we have a situation where the market isn’t growing and nearly all issuance is for refinancing. But for investors looking for a decent yield in the public markets, the case for an allocation to high yield still makes sense. If you look at spreads over the past six months, they have seen significant tightening, despite the selloff in rates. That speaks volumes for how strong the technicals are: there a lot of investors who want more yield than they can get on government bonds or money market funds.  

BP: If you ignore the fallen angels who came into the high-yield market during the pandemic, the market hasn’t actually grown since 2016. Going back to the earlier question of whether the market is expensive, what the technicals and history show you is that if the economy is doing okay and if default rates are reasonable, we believe many investors will be willing to buy high-yield bonds at spreads between 300 and 400 basis points. You have certain investors like insurance companies and pension funds who have obligations and they need to buy high yield to make their asset-liability models work.

References

1.Financial Times, ‘Investors pour money into US corporate bond funds at record rate’, March 24, 2024
2.Bank of America Global Research, ‘US High Yield Strategy Report’, March 22, 2024
3.Reuters, ‘Carnival rides on record cruise demand’, March 27, 2024
4.Deloitte, ‘2024 Digital Media Trends’, January 2024

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of April 2024 and may change without notice.

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Index Descriptions

HW0C – The ICE BofA ML Global High Yield Constrained Index contains all securities in The ICE BofA ML Global High Yield Index (HW00) but caps issuer exposure at 2%.

J0A0 - The ICE BofA ML US Cash Pay High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt, currently in a coupon paying period that is publicly issued in the US domestic market.  Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

HE00 - The ICE BofA ML Euro High Yield Index tracks the performance of EUR dominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million.  

C0A0 - The ICE BofA ML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

EMCB - The ICE BofA ML Emerging Markets Corporate Plus Index tracks the performance of the U.S. dollar and euro denominated emerging markets non-sovereign debt publicly issued in the major domestic and eurobond markets. Qualifying issuers must have risk exposure to countries other than members of the FX G10, all Western European countries, and territories of the U.S. and Western European countries.

UR00 – The ICE BofA Sterling Corporate Index tracks the performance of GBP denominated investment grade corporate debt publicly issued in the eurobond or UK domestic market.

HL00 – The ICE BofA Sterling High Yield Index tracks the performance of GBP denominated below investment grade corporate debt publicly issued in the sterling domestic or eurobond markets.

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