Is US high yield debt on borrowed time?

The strength of the US economy in 2023 has defied expectations, with growth-sensitive assets like the S&P 500 Index now up 19% for the year. Riskier parts of the US credit markets have also held up.

But we see reasons for some caution on the outlook for US high yield debt in the late-cycle environment we expect for the year ahead. We hold a neutral view on US high yield in our global strategy. Higher interest rates today could put pressure on the ability of companies to refinance. The US high yield market has experienced a 60% year-on-year increase in issuance this year—but no such openness for lower-rated CCC issuers. These riskiest borrowers have only managed to issue USD 7.2bn of bonds, down 57% year-on-year and the lowest year-to-date figure since 2009, according to Pitchbook LCD data.

And while US high yield spread widening is likely to be contained in our base of slowing growth but no recession, we think the extra yield investors receive over US Treasuries to hold high yield debt (the credit risk premium) is too low. At present, this risk premium is consistent with a default rate of 2–3% rather than the 4% we expect in 2024. Fundamentals are weakening—US high yield gearing ratios have been rising and interest coverage ratios have fallen back below 5x for the first time in a year.

But we do see opportunities for investors to diversify with alternative credit in the year ahead, in order to navigate the risks and benefit from bigger swings in bond prices and spreads:

Specialist credit hedge funds can turn dislocations to their advantage. Hedge fund managers that specialize in taking long and short positions to exploit credit market mispricing have delivered positive returns this year, and we think they're set for another favorable year ahead. The sector has delivered 6.2% total returns this year, based on the HFRI ED: Credit Arbitrage Index. We expect elevated dispersion in high yield spreads (yield over US Treasuries) between stronger and weaker borrowers to persist next year. This is a fertile environment for active managers to deliver manager-led outperformance (or “alpha”), in our view. Hedge funds also have the ability to selectively seize such opportunities and apply strict risk limits in ways traditional investors cannot.

Dedicated distressed debt managers may help investors navigate a wall of maturing debt. Nearly USD 1tr of market value in global high yield debt and convertible bonds will approach maturity in 2025 and 2026. Some firms that issued these securities in the former low-interest-rate world may struggle to refinance, or even fall into financial distress. We therefore see good opportunities in distressed and special situation funds for the year ahead, with a consistent source of deal flow likely to be focused in areas of the market that have already seen some dislocation, with properties in bankruptcy and tenant distress.

Credit hedge funds may help build more resilient portfolios. Alternative credit funds can use derivatives to hedge market exposure, offering investors lower volatility and/or moderate correlation to broader credit indexes. They can help offset traditional portfolio losses in market sell-offs, add alpha in periods of rising equity markets, and capture return streams not available to traditional markets. Credit long/short funds historically, for instance, have acted as a portfolio diversifier too, outperforming traditional credit roughly two-thirds of the time after a market sell-off, according to HFRI RV: Fixed Income Corporate Index and Bloomberg US Corporate IG Index data since 1993.

So, we suggest using today’s market conditions to diversify portfolios via alternative credit managers for 2024. There are risks to consider when investing in this strategy, however. Alongside illiquidity and lower transparency than public markets, credit arbitrage strategies are subject to near-term losses arising from higher levels of corporate distress, even if such distress may open up long-term opportunities. This underlines the importance of managing risk in stressed single-name credit and considering managers that use derivatives to reduce beta or portfolio swings from changes in the index.

For more details on these ideas and more, click here for our Year Ahead 2024: A new world.