As the US economy begins to feel the weight of the Federal Reserve’s rate hikes, investors have grown leery of US high-yield corporate bonds. On the surface, that makes sense. Historically, credit conditions soured when growth slowed. But instead of bracing for a wave of downgrades and defaults, we think income-seeking investors should embrace high yield. Here’s why.
Reason 1: Strong fundamentals late in the credit cycle.
If the US economy enters and remains in a low-growth phase, the high-yield sector isn’t at great risk of a downturn. But the banking crisis has increased the odds of a hard landing.
At the brink of most slowdowns, corporate fundamentals are typically already weak. And it’s true that high-yield issuer fundamentals are beginning to weaken now. But they’re starting from an unusually strong position at this late stage of the credit cycle.
Today’s high-yield bond issuers are in much better shape financially than issuers entering past slowdowns, thanks in part to an extended period of uncertainty surrounding the coronavirus pandemic. This uncertainty led companies to manage their balance sheets and liquidity conservatively over the past few years, even as profitability recovered. As a result, leverage and coverage ratios, margins, and free cash flow improved. This relative strength in balance sheets means corporate issuers can withstand more pressure as growth and demand slow.
Prudent fiscal management isn’t the only reason the corporate universe is well positioned to weather a storm. The default cycle triggered by the pandemic—with defaults peaking at 6.3% in October 2020—effectively cleaned up the sector. The weakest companies defaulted and are now no longer part of the investable universe. The surviving companies were the strong ones.
That was less than three years ago. Since then, there simply hasn’t been enough time for the survivors to develop unhealthy financial habits. As a result, we expect the US default rate to remain low for the next 12 to 18 months—around 3% to 4%. Plus, the share of the high-yield bond market that is secured—31% as of December 31, 2022—is high by historical measures. That may translate into higher recovery rates for high-yield bonds in the event of default.
The pandemic-led wave of defaults and downgrades also strengthened the average quality of the high-yield market. Even as many of the lowest-rated high-yield bonds defaulted and fell out of indices, many of the lowest-rated investment-grade bonds fell into the high-yield market as fallen angels. Consequently, the quality of today’s high-yield market is unusually high, with BB-rated bonds currently comprising 49% of the market, versus 43% on average over the past 20 years.
That said, in our analysis, high-yield investors should favor higher-quality credits, be selective and pay attention to liquidity. Lower-rated credits are most vulnerable in an economic downturn. Investors may also want to be selective with high-yield bank loans, which are more vulnerable than high-yield bonds to a downturn, in our view.
Reason 2: Extended maturity runways.
Extended maturity runways are also taking some financial pressure off high-yield issuers. Companies have focused on extending their maturity runways since the start of the pandemic. That means there’s no approaching maturity wall, where a large share of bond issues matures and issuers are compelled to procure new debt at prevailing rates. In fact, only 5% of the market will mature by the end of 2024, with the lion’s share of maturities coming between 2027 and 2033.
This is akin to opening a pressure valve as yields rise, because gradual and extended maturities will slow the impact of higher yields on companies (Display). Today, the average high-yield coupon is 5.8%—significantly lower than the current yield to worst, at 8.5%.
