However, this widening should present buying opportunities, given our expectation that defaults, albeit higher will overall be contained. This is especially true for quality companies’ bonds. As is usually the case during market downturns, there are likely to be dislocations and strong companies will widen in sympathy with the overall market. Given that the yield for the BofA HY index is approaching 8.5%, a widening in spreads can lead to attractive investment opportunities for investors with longer time horizons.
Spreads are at historical average levels. The spread on the BofA HY index is 435bp, which is slightly tighter than the ten-year average spread of 448bp and is below the 20-year average level of 524bp. During the last hiking cycle of 2018, HY spreads widened from around 320bp to 540bp and during the commodity crisis of 2015/2016, spreads widened from around 450bp to 900bp. As we discussed in our recent Fixed Income Strategist, spreads within risk assets are likely to be volatile in 2023, as the market experiences below trend growth. We anticipate that the slowing economy this year will cause a reduction in corporate margins, weakening balance sheets, and a rise in default rates, leading to wider spread levels. Importantly, the risk/reward in HY is not attractive on a relative basis and in the current environment, investors should benefit from moving up in quality.
Looking at breakevens, the breakeven spread is 114bp, meaning that spreads can rise by 114bp over the next year before the HY market begins to underperform similar average life treasuries. However, when taking a shorter time horizon of six months, the breakeven spread is merely 57bp – a move that we feel is easily plausible and would erode HY returns.
The timing of any potential widening in spreads is difficult to predict. The market is currently focused on declining inflation, a likely Fed pause, and a resilient labor market, which are grinding spreads tighter by 48bps year-to-date. However, other economic indicators such as the PMIs are suggesting that spreads should be wider. Ultimately, we believe that volatility will persist and investors should take advantage of opportunities presented by market sell-offs.
Yields, on the other hand, are close to historical highs. In recent history, HY yields surpassed 9% only on several occasions (1998, 2007, 2011, 2016, 2020, and 2022). When the HY market yields reached 9%, the cumulative total return that followed was mixed over the following six- and 12-month periods, but was positive and almost always very strong over a longer term horizon, averaging 17.5% over two years. This analysis suggests that if spreads widen, as we expect, the HY market should present attractive investment opportunities.
The higher quality HY credits, as represented by the ICE BofA BB index, are yielding 6.7% with a spread of 276bp. However, this spread is merely 109bp wider than the BBB index. As the companies begin to feel the impacts of a slowing economy, we project the spread of BB to BBB credits to widen. During periods of economic volatility, the BB to BBB spread differential tends to rise past 150-200bp. We would view this potential spread widening as a buying opportunity of many high quality high yield credits.
We identified a basket of 17 HY companies that we believe to be high quality, stable credits that should be able to withstand a weaker economic environment. These are the bonds that investors should focus on in a widening environment, in our opinion. They represent a variety of industries, including autos, basics, industrials, consumer goods, food, energy, leisure, transportation, TMT and utilities. The yield today on the basket of representative bonds is 5.8% with a spread of 219bp. At the moment, we do not believe that this valuation is compelling, as it is merely a pick-up of 25bps in yield from the BBB index. However, if the projected decompression in spreads occurs, this is the basket of companies where investors should be able to find attractive, resilient opportunities in.
For more details on CIO Fixed Income views, please see the Fixed Income Strategist published on 10 January 2023.
Content is a product of the Chief Investment Office (CIO).
Main contributors: Alina Golant, Leslie Falconio
Original blog - High yield 2023 outlook, 11 January, 2023.