Risk assets, particularly high yield corporate bonds (HY) and senior loans, have enjoyed an outstanding year so far. In the first six months of 2023, the ICE BofA US High Yield Index was up 5.4%, its best first half since 2019, while the S&P/LSTA US Leveraged Loan 100 Index returned 6.5%, its best since 2009. The market consensus has underestimated the resiliency of the US economy and the strength of the US consumer, and risk assets have mostly ignored the lagged impact of the 525-basis-point rate increase in the federal funds rate in 16 months. This has confounded many investors who shied away from the benefit of higher yields with deeper embedded credit risk.
CIO has remained neutral on HY and loans for most of 2023, reflecting mainly our view of relative value rather than the expected catalyst of spiking default rates. Unlike prior economic recoveries, this post-pandemic period has seen the market feeding off the unprecedented monetary and fiscal stimulus, alongside an economic recovery that has been driven by employment. By contrast, past expansions typically relied heavily on debt, resulting in aggressive lending and inflated risk assets. This difference has served as a tailwind to performance in 2023. But with default rates starting to normalize, we do not believe current spreads are appropriately compensating investors to take on the additional embedded credit risk in HY or loans, and we maintain a neutral positioning.
Correlation to volatility
Although the HY market is influenced by fixed income volatility, the correlation is higher for volatility from the equity market, i.e., the VIX versus the MOVE index. We ran the scatter plot and correlation over the past five years Although equity volatility has remained unusually low versus fixed income volatility, this has been a tailwind to total return within HY. Given the performance of the equity market in the first half of 2023, and our expectation of slower growth toward the end of the year, we anticipate volatility will switch from a tailwind to a headwind during 2H23.
The euphoria of upgrades witnessed in the first half of the year appears to be stalling. While tighter lending conditions alongside higher borrowing costs have negatively impacted the loan market this year, HY has shown positive momentum. Only recently have downgrades begun to dominate. This coincides with the higher number of bankruptcies in 2Q23. While we do not anticipate this trend to deepen, the tailwind from upgrades within HY is likely behind us.
With the federal funds rate at 5.5%, the highest since late 2000, it is expected that interest rate coverage would decline. While issuers may not be paying the interest advertised in the “open market” (as discussed above), the velocity of the rise in short-end rates and a spike in the cost of capital for a longer period will continue to be a drag on interest coverage ratios. However, although interest coverage has been declining, it remains above pre-COVID levels. As it relates to the correlation between lower interest coverage and rising defaults, we note that it historically is not declining coverage alone that leads to higher defaults but rather in combination with the factors that we previously discussed.
Default and recovery
The United States saw a total of 340 bankruptcies in the first six months of 2023. This is more than the bankruptcies in the first half of 2020, when the country went into a full lockdown, and the most for a first-half period since 2010. Businesses are feeling the pain of higher interest rates.
In HY, a monthly average of USD 8.7bn of bonds and loans have been affected by default or distressed exchange activity in 2023, versus USD 2.6bn across 2021–22 and USD 4.1bn post-global financial crisis. Including distressed exchanges, the par-weighted US HY default rate is 2.71%, which is up from the 1.65% rate to start the year and is expected to increase from current levels.
We expect HY and loan defaults to trend higher over the remainder of the year, ending 2023 within a range of 4.5–5% for HY due to the greater burden of interest expense, tighter lending conditions, and more limited capital access resulting from stress in the banking sector and inflation uncertainty.
Historically, HY defaults continue to rise about 1.5 years after the cycle peak in the fed funds rate. While lower leverage and stronger balance sheets should keep HY defaults contained, at spread levels of 380bps investors are not adequately protected for rising defaults. At these spread levels, investors are compensated for a default rate of about 2.5% (when assuming a spread of 380bps and a 30% recovery and 3% long-term default) rather than the 4–5% we anticipate in the next 12 months.
While higher yields—8.5%—provide an enhanced cushion for HY investors, sustained elevated defaults can erode this cushion over an extended period. For example, as recently discussed on Bloomberg Intelligence, during the four-year period of 1999–2002, when HY yields were between 10.5% and 14%, the total cumulative return was near zero.
While the current yield in HY is a positive tailwind to total return, the rise in US Treasury rates continues to be a contributor to these decade-high levels. With the outperformance of lower-quality credit over the year, investors need to be selective with positioning and allocation. While we remain neutral on HY, we recommend an allocation to the short end, with the overall preference to the higher-quality issues.
Main contributor: Leslie Falconio
Read the full report for more, Fixed income credit: What we are seeing, doing, and watching 11 August 2023.