Elevated interest rates and wider credit spreads have increased the yields on high yield. But recession fears are leading to questions about the outlook. We maintain a least preferred view on US high yield and recommend that investors review their holdings.
A jump in interest rates and credit spreads have increased the yields available on high yield credit. Yet fears about a potential US recession are leading many investors to question the outlook for riskier credits.
We retain a least preferred view on USD high yield credit because a) spread compression this year on hopes of a Fed pivot is too early, b) there is further policy tightening in store, and, c) a slowing economy should weigh on corporate earnings and likely increase defaults.
We are forecasting the corporate default rate to rise to mid-single digits over the next 12 months, compared to the current level of 1.6%.
The Federal Reserve (Fed) has told the market what it will do—so pricing in a pivot at this stage when Fed officials expect to raise rates by a further 75bps is premature. This is particularly the case when the 425bps of tightening delivered over the past year is still working its way through the system and not fully reflected in corporate fundamentals. This has implications for credit risk premiums (the compensation credit investors required over and above expected credit losses), which could widen significantly.
But a least preferred view on US high yield does not correspond to an outright sell signal. We recommend allocations to US high-yield credit up to 6% in our House View strategic asset allocations (SAAs), and up to around 15% in select Yield-Focused and All Fixed Income SAAs. We will tactically adjust these recommended allocations based on current preferences, but still maintain appropriate exposure to the asset class.
For those in-line with the recommendation, and who are willing to endure mark-to-market volatility, we see justification for riding out the likely near-term downside. The current level of outright yields in US HY and EU HY are around 8% and 7% (in local currency), respectively, at an index level. This is appealing relative to history and potential returns in other asset classes.
Additionally, the repricing in spreads and yields has happened in a short period of time, creating a scenario where the majority of bonds are currently trading at deep discounts to par and hence generating positive convexity. This means that prices will rise by more on a decline in yields than they would fall on a comparable rise in yields. Also of some comfort is the fact that we have not seen the classic buildup of financial excess and leverage since the last default cycle in 2020.
For investors that are overexposed to HY, we recommend selling excess holdings in favor of our preferred areas within fixed income, i.e. US investment grade credit, and Agency MBS.
For investors who are tactically minded and underexposed, we recommend taking advantage of market volatility to look for opportunities in high quality HY credits. Given concerns about market liquidity and expected headwinds for earnings, we think spreads could reprice wider, but by moving up in quality, we believe investors can still benefit from higher outright levels of rates and reduce their credit spread volatility in the process.
For more read our latest blog "High Yield 2023 outlook" and our latest report "Fixed Income Strategist," published 10 January 2023.
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For more on high-yield bonds, watch the UBS Trending episode No risk, no reward.
