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High-yield bond credit spreads have widened in recent weeks amid higher investor risk aversion following the well-publicized stresses in the banking sector. However, we believe it is still too early from a cycle standpoint for market participants to position their high-yield portfolios more aggressively. Instead, we would suggest a slightly defensive to neutral risk posture in the space for now.
Our rationale? Historically, high-yield spreads (and spreads for risk assets in general) have sold off when the US Federal Reserve (Fed) was cutting interest rates. Given our belief that it will be many months before the Fed starts lowering rates, we suspect it would be premature for investors to up their high-yield risk exposure at this juncture.
We had already forecast the US economy to enter a mild recession during the second half of this year, as we wrote in our high-yield outlook (published in January 2023). Central bank monetary policy tends to work with a “long and variable lag,” so because the Fed only began hiking rates a little over a year ago, the impact on the economy is still largely unknown. Bank lending standards, which had already been tightening prior to the recent sector shakeup, will likely tighten even further, which would increase the probability of a more severe economic downturn.
If the Fed ultimately realizes that it has hiked rates too far, it will likely decide to quickly pivot to cutting rates — but by then, it may be too late to undo all the damage. High-yield investors may be inclined to draw a similar conclusion at that point, potentially causing high-yield spreads to widen as has occurred in the past (Figure 1).
Thus, we believe there may be compelling opportunities for investors to add high-yield risk at wider spreads after the Fed begins to cut rates. (Again, though, we would advocate for more cautious positioning until then.) Further, security selection in this market will likely take on greater importance going forward. In particular, consider avoiding possible trouble spots, like issuers trying to pull off a turnaround or those overly exposed to leverage or cyclicality. We do not believe today’s uncertain environment warrants giving these types of companies the benefit of the doubt.
High-yield credit fundamentals are starting from a position of strength, based on elevated interest coverage and relatively low leverage as of this writing, although we expect some weakening in the coming quarters as economic growth likely slows. We also anticipate that high-yield default rates may rise toward long-term averages (~4% – 5%) over the next 12 months, but we do not see a big wave of defaults on the horizon. One factor that should help limit the number of defaults is the strong quality composition of the high-yield market, less than 11% of which is CCC rated (the lowest quality tranche), compared to more than 22% just before the 2008 global financial crisis (GFC).
Speaking of the GFC, that episode was just one historical example of a period in which high-yield credit spreads spiked and overshot their “fair value” based on actual realized default rates. That could happen again, which is why we cannot necessarily rest on the current strength of high-yield market quality as assurance against sharp spread widening in the period ahead.
In our view, "reaching for yield” would not adequately compensate investors at current high-yield spread levels given today’s macroeconomic headwinds, softening fundamentals, and ongoing heightened market volatility. As a result, we believe it is too early yet to become aggressive with one’s high-yield positioning, but we do believe more attractive opportunities to (judiciously) assume increased risk should arise later this year. In the meantime, look out for emerging stresses in other credit markets (e.g., real estate, private middle-market credit) that appear especially vulnerable and what the potential spillover effects to high yield might be.
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