Wednesday, September 6, 2023
A few months ago we asked the question (blog post here): Has the corporate credit market lost its mind? At the time we were perplexed by the continued resilience and outperformance of the Bloomberg U.S. Corporate High Yield Index despite the increase in downgrades and defaults, which serve to eat away at future returns. Since then, however, downgrades and defaults have continued to increase and yet high yield spreads, or the additional compensation for owning risky debt, continue to tighten. So this week, we’re ready to declare that, yes, the high yield market has in fact lost its mind and we don’t think it properly reflects deteriorating fundamentals and the elevated refinancing risks of the companies most prone to default.
High yield corporate defaults picked up again in August with the high yield default rate at 2.4%, with the expectation that it will increase to 3.25% (per JPMorgan) by the end of next year. Defaults represent companies that are unwilling or unable to pay their debts back in a timely fashion and thus do not pay their debts back at par. And while defaults have started to increase, deteriorating fundamentals will likely continue to pressure lower-rated borrowers, particularly if the Federal Reserve (Fed) keeps interest rates elevated.
Currently, more than half of CCC-rated borrowers have earnings that are lower than their interest payments, making future payments and refinancings potentially problematic. And unfortunately for these borrowers, debt refinancings are set to pick up with nearly 30% of debt issued by CCC-rated companies coming due over the next few years. And the calculus doesn’t look great for these companies. If the Fed keeps interest rates higher for longer, that means newly issued debt by these companies will become more expensive than their existing debt. However, if the Fed has to cut rates due to a hard landing (not our base case), it would likely make debt cheaper, but the souring economic environment would also likely negatively impact earnings for these companies. Neither option looks particularly enticing if you’re a high yield borrower. And yet, spreads for these issuers are only trading around historical averages.
So what is keeping spreads contained? Better than expected economic news, low equity volatility, and very little new supply. But as mentioned, the supply/demand dynamics are set to change. And while there’s no doubt the economic data has been favorable for risk assets lately, eventually the lowest-rated cohort within the high yield index will face funding pressures that could lead to more defaults. S&P, a rating agency, has downgraded the outlook for 164 high yield companies this year (versus only 18 upgraded outlooks), which is three times as many as last year and represents the worst upgrade/downgrade ratio in years. So, with valuations continuing to shrug off bad news and with the evidence building that downgrades and defaults are likely going to keep moving higher, we don’t think the risk/reward for owning high yield is very attractive.
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