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In mid-December 2022, our high-yield strategy group met to discuss the outlook for the global high-yield market over the coming 12-18 months.
Although we see continued macroeconomic headwinds in 2023, combined with defaults heading back toward long-term averages, we think a repeat of 2022’s negative total-return year is unlikely. Further, with global high-yield credit spreads now above 500 basis points (bps) and “all-in” yields north of 8.9%, we believe market technicals could turn positive as investors seek to capture spreads and yields that are significantly higher than a year ago.
As of this writing, we favor a modestly defensive risk posture but with flexibility to “pivot” should further high-yield market volatility present opportunities to tactically add risk exposure at more attractive valuations. Security selection should also take on increased importance in 2023 because we anticipate greater dispersion across high-yield issuers, sectors, and quality buckets. As such, we continue to prefer companies that can maintain their cash flows in a more challenging market environment through strong competitive positioning or organic de-leveraging of their balance sheets.
A mild global recession beginning toward the second half of 2023 remains our base case right now. However, we believe the risk of a “rolling” recession – one where different sectors of the economy suffer downturns at different times – has increased, which would likely be more severe and could pose a stiffer headwind for many high-yield issuers.
The US Federal Reserve’s (Fed’s) more contractionary monetary policy over the past 12 months, designed to curb persistent inflation, has brought the US yield curve to its flattest since the 1980s – historically, a pretty reliable indicator of an approaching recession. While the pace of inflation has decelerated recently, it is still unclear where inflation will settle and whether the Fed will feel compelled to keep raising interest rates. On the plus side, credit growth, excess savings depletion, labor gains, and housing wealth all boosted consumers’ health in 2022. Nevertheless, we do not believe the true cumulative effects of tighter policy on consumers will take hold until mid-2023.
Bottom line: The macroeconomic landscape remains challenging, and we expect global growth to continue to slow in 2023.
Despite rising input costs, high-yield issuers’ fundamentals held up relatively well in 2022. Many issuers have bolstered their balance sheets since the onset of COVID-19, providing some insulation from rising costs. However, we anticipate continued pressure on many issuers’ profit margins, as higher costs might not be so easily passed on to a flagging consumer sector in 2023. All-in borrowing costs are significantly above where they were a year ago, further cutting into corporate free-cash-flow generation.
Overall, we expect high-yield corporate fundamentals to weaken over the next six to 12 months, as the lagged effects of tighter monetary policy work their way through the economy.
While corporate fundamentals have already worsened over the past 12 months, the incidence of high-yield defaults has remained benign, with an average default rate of around 2.5% over the past 12 months (according to Moody’s).
With our forecast of a recession and further margin compression in 2023, our base case is for high-yield defaults to end the year in the 4% to 5% range. This default experience would be in line with historical averages and well below previous recessionary peaks. Despite the fundamental challenges noted above, most high-yield issuers are starting the year in decent shape. Limited maturities through 2024 should also help to keep the overall default rate in check.
Relative to the start of 2022, both spreads and all-in yields are now significantly higher for the global high-yield market. As of 31 December 2022, the option-adjusted spread of the ICE BofA Global High Yield Constrained Index was 515 bps, modestly above the median point of historical observations (53rd percentile). Additionally, the index was yielding above 8.9% (yield to worst), with an average dollar price of 85.
While the market may be prone to volatility over the course of 2023, we believe high-yield spreads could grind tighter in the absence of negative news, especially given the lack of new high-yield supply and a potential pause of hawkish Fed actions in the first half of 2023. However, we believe spreads may widen in the second half of 2023 as corporate fundamentals continue to weaken amid the slowing macroeconomic environment. If this were to occur, we believe it may present attractive buying opportunities for high-yield investors.
As we enter 2023, we believe a modestly defensive risk posture, with a strong emphasis on security selection, is appropriate. Given the macroeconomic headwinds, weakening high-yield issuer fundamentals, and median-level valuations in the sector, we do not believe investors are likely to be adequately compensated for taking on excess credit risk. However, in the event of further market volatility, maintaining the flexibility to pivot and tactically increase risk at potentially more attractive valuations may prove beneficial.
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