Viewpoint | December 22, 2023
The Impact of Higher Rates on Developed Market High Yield: Headwind or Opportunity?
After over 18 months of interest rate hikes, developed market policy rates may have peaked. Rate cuts potentially turning into a tailwind would be good news for fixed income returns. In a ‘higher-for-longer’ environment, rates could stay elevated, which has implications for high yield issuers’ cost of refinancing and access to the primary bond market.
On the other hand, rates have played a significant part in lowering the average price in the US and European high yield markets to around 90, a level largely unseen outside of short periods of credit dislocation over the past decade.1 Understanding the timing of how issuers address the refinancing of low coupon bonds priced below par can provide investors with interesting entry points into the asset class.
The Shape of the Maturity Walls
High yield companies generally prefer to have bond debt accounted for as a long-term liability on their balance sheets. The main reason for this is that issuers need market access to roll their maturing debt, and a current bond maturity exposes the company to severe default risk if the capital markets are closed when the bond matures. There are also several qualitative problems for high yield companies when their debt moves to a current liability, notably audit opinion issues, rating agency downgrades and public equity valuation concerns. Thus, calling bonds at least 1-year prior to maturities is a common occurrence in high yield.
Many high yield companies have multiple bond issues outstanding at any given time with staggered maturities. In Europe, the maturity wall is skewed forward with approximately 50% of bonds needing to be refinanced by year end 2026 (Fig. 1). However, US maturities are spread more evenly with less than 25% due for a refinancing in the next three years (Fig 2).
It is important to understand market nuances when comparing the maturity profiles. Most new issues in both markets are issued with call provisions, therefore providing issuers flexibility to manage their maturity walls. Market convention in the US is for longer maturities with the typical new issue maturing in 7-10 years, while the European market usually issues in the 5-7-year window. The other differentiation comes from Europe’s larger share of fallen angels (currently around 12%),2 which typically do not have a call feature. This means that issuers cannot redeem the issues until the maturity date, therefore limiting refinancing flexibility and potentially shortening the maturity wall.
When Will Issuers Face Higher Financing Costs?
High yield issuers were able to take advantage of the low yield sovereign debt environment that existed in the post-Global Financial Crisis (GFC) era. Coupons declined steadily for the last decade and hit their nadirs during late July 2021 in Europe3 and January 2022 in the US4. However, coupon rates have increased since this time as central banks ratcheted up their short end rates while simultaneously moving into a quantitative tightening mode for longer-term bonds. This leads to the following questions: Is the golden rate era over and, if so, what are the ramifications for corporate issuers?
Given the staggered maturity profiles across developed markets high yield with low existing coupons, we expect average coupons in developed market high yield to only increase gradually over time assuming a higher for longer period. A simplistic approach toward estimating the total change in coupons and financing cost for the market is to review the current YTW and compare it to the market weighted coupon. In the US this would result in a 2.37% increase in the average coupon paid by high yield issuers, a 39% increase in costs relative to current coupons.5 This would be a large increase and could lead to stress in the market as issuers experience increased interest expense.
However, not many bonds in the market need to be refinanced today, and the projected annual increases in average coupons for the market is much more manageable at 0.18-0.44% per annum through 2027 based on the maturity profile, assuming refinancing 1-year prior to maturity. The coupon impact on European issuers is slightly more accelerated given the steeper maturity wall.
This analysis indicates that the annual change in interest expense for the US high yield market is manageable into the foreseeable future. However, the analysis overstates the impact on most issuers who will see less impact from the increase in rates since companies rated B3 and lower will see the bulk of the major increase in expense and are skewing the average higher. This is especially evident since the B3 and lower-rated market only comprises 21% of the US and 12% of the European high yield markets.
While interest expense will likely increase over time, issuers are starting from a very healthy balance sheet position. Leverage and interest coverage ratios are still at very strong levels when compared to long-term averages. This provides issuers with substantial financial flexibility to manage their business and balance sheets in a higher-for-longer environment. At the same time, investors will participate in the higher-for-longer era by earning more interest income without seeing a material reduction in financial metrics. This is potentially a win-win for all.
The Maturity Wall is an Opportunity
Meanwhile the maturity wall is resulting in many issuers refinancing at least one year before a bond’s maturity to reduce risk around market access and credit downgrade by the rating agencies. Early refinancing of bonds often results in losses for investors during periods of a normal upward sloping yield curve since bond prices are often higher than call prices. However, bond prices are now less than par given the large increase in rates and the inversion of the yield curve. Being called out of a bond at par is now an opportunity for investors to see positive excess returns from the positive pull-to-par scenario. This early pull-to-par convexity results in returns that are greater than those implied by the yield-to-worst calculation.
The Power of Pull to Par
- Yield to worst calculations may underestimate the potential realised return for bond investors.
- Issuers refinance usually at least one year before the bond maturity to reduce risk around market access: this could lead to a higher total return than the yield to worst.
- When the price of callable bonds is below 100, the yield to worst is equivalent to the yield to maturity since the call option is out of the money.
Are Investors Compensated?
The sharp move from zero/negative rates to higher rates has resulted in high yield ‘normalisation’, with yields back to levels last seen around a decade ago. Wider spreads have accompanied this move.
By component, the yield is the measure of potential total return while spread is the compensation for default risk. Spread was the driving force for returns post the GFC, given low government bond yields, but that has changed as bond yields have risen.
Yields currently stand at 7.06% in Europe6 and 8.45% in the US7, indicating investors can expect an attractive return from the asset class over a 1-year horizon; the higher US yield being a function of higher US base rates. In spread terms, the US at 397bps8 is slightly inside the spread in Europe of 438bps9 despite Europe having a somewhat better average credit rating. Thus, both markets offer interesting return opportunities for investors. The pull-to-par from early calls would only enhance potential investor returns since they are not part of the yield-to-worst calculation.
While the higher for longer rates narrative is resulting in fears of growing defaults, issuers are in solid financial shape and investors can earn higher yields without needing to take larger risks – unlike the quantitative easing years where investors were forced down the rating spectrum in their reach for yield.
- Today investors can take advantage of higher base rates which translate into higher yields, while reasonable spreads compensate for the default risk in the current economic and credit environments.
- There is increasing rate pressure on weaker companies – especially CCC rated bonds – and they are likely to struggle with higher interest costs. While their yields may rise even further, so will default risks in this cohort as we move through 2024.
- The positive convexity of bond prices and the pull-to-par associated with early refinancing activity can enhance investor returns.
- In this environment, we believe higher quality high yield credits with solid fundamentals are a compelling choice for investors as part of diversified asset allocation strategies.
Overview of our Analysis
In the analysis on page 6, we consider the combined impact of a change in credit spreads and interest rates on the ICE BofA Developed Markets High Yield Constrained Index (HYDC) potential gross return over the next twelve months. A change in credit spreads and interest rates is assumed to take place at the start of the period of analysis. These represent the two variable inputs in this analysis, shown along the vertical and horizontal axes of the following matrix.
The matrix presents the anticipated gross returns of the fund over the following time period.
Important Notes and Assumptions:
- The analysis aims to estimate the ICE BofA Developed Markets High Yield Constrained Index (HYDC) gross return potential between 1st December 2023 and 30th November 2024
- The simulated returns are shown in USD. Simulating performance in different currencies would produce different simulated returns that may be more or less favourable.
- The analysis assumes the index to be a single bond that has the weighted average characteristics of the Fund.
- The analysis is based on assumed price movements observed at the start of the period, as a result of a combined change in interest rates (Rates) and credit spreads (Spreads).
- All other factors including – for example - index holdings, are assumed to be kept constant.
- The assumed changes in Rates and Spreads are applied to the index as a whole, and therefore an equal shift on all holdings is assumed.
- Over the period of this analysis, potential gross returns are calculated by combining the initial positive or negative effect of the assumed change in Spreads and/or Rates, with the subsequent yield of the portfolio over the period.
- Though model based, the calculations make a number of assumptions that may or may not be accurate and future duplication may not be possible.
- This analysis may not accurately capture the performance of callable bonds or loans that can either trade to maturity or to an earlier call date.
- The analysis assumes that no holdings are retired early at a premium.
- The analysis does not capture the impact of interest rate futures or CDS indices that may be held in the portfolio for hedging purposes.
- The information is confidential and may not be reproduced or distributed without the express prior written consent of Muzinich & Co. Limited.
1.ICE Data Platform, ICE BofA US Cash Pay High Yield Index (J0A0), ICE BofA European High Yield Constrained Index (HEC0), as of 17th December 2023.
2.ICE Data Platform, ICE BofA European High Yield Constrained Index (HEC0), as of 17th December 2023.
3.ICE Data Platform, ICE BofA European High Yield Constrained Index (HEC0), as of 29th July 2023.
4.ICE Data Platform, ICE BofA US Cash Pay High Yield Index (J0A0), as of 17th January 2022.
5.ICE Data Platform, ICE BofA US Cash Pay High Yield Index (J0A0) as of 30th November 2023
6.ICE Data Platform, ICE BofA Euro High Yield Index (HE00) as of 30th November 2023.
7.ICE Data Platform, ICE BofA Cash Pay US High Yield Index (J0A0), as of 30th November 2023.
9.ICE Data Platform, ICE BofA Euro High Yield Index (HE00) as of 30th November 2023.
HEC0 - ICE BofA European High Yield Constrained Index - The ICE BofA ML Euro High Yield Constrained Index contains all securities in the ICE BofA ML Euro High Yield Index (HE00) but caps issuance exposure at 3%.
HP4N – The ICE BofA ML BB-B European Currency Non-Financial High Yield Constrained Index contains all non-financial securities in The ICE BofA ML European Currency High Yield Index rated BB1 through B3, based on an average of Moody's, S&P and Fitch, but caps issuer exposure at 3%.
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.
HYDC - ICE BofA Developed Markets High Yield Constrained Index - ICE BofA Developed Markets High Yield Constrained Index contains all securities in The ICE BofA Global High Yield Index from developed markets countries, but caps issuer exposure at 2%. Developed markets is defined as an FX-G10 member, a Western European nation, or a territory of the US or a Western European nation. The FX-G10 includes all Euro members, the US, Japan, the UK, Canada, Australia, New Zealand, Switzerland, Norway and Sweden. Index constituents are capitalization-weighted, based on their current amount outstanding, provided the total allocation to an individual issuer does not exceed 2%. Issuers that exceed the limit are reduced to 2% and the face value of each of their bonds is adjusted on a pro-rata basis. Similarly, the face values of bonds of all other issuers that fall below the 2% cap are increased on a pro-rata basis. In the event there are fewer than 50 issuers in the Index, each is equally weighted and the face values of their respective bonds are increased or decreased on a pro-rata basis. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index. Information concerning constituent bond prices, timing and conventions and index governance and administration is provided in the ICE Bond Index Methodologies, which can be accessed on Bloomberg (IND2[go], 4[go]), or by sending a request to email@example.com. The index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. No changes are made to constituent holdings other than on month end rebalancing dates.
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