As US companies revise their earnings forecasts en masse and fears of recession-induced defaults increase, some investors feel it’s a good moment to get into high yield corporate debt. The key question: what will be the nature of the upcoming recession?
“A rare opportunity to get into high yield,” noted bond strategist David Furey of State Street Global Advisors in a market review last week. “A fantastic buying opportunity for US high yield,” said Dutch investment advisory firm Candoris.
The optimism contrasts with talk of an increase in the expected default rate. In February, UBS Asset Management was still talking about a percentage of less than 1 percent for Europe and less than 2 percent for the US. But Barclays currently projects a default rate of 3.5 to 4 percent for the next 12 months.
“Indeed, the outlook for defaults has deteriorated rapidly,” said SSGA’s Furey. “Margins are expected to come under pressure from higher input costs, together with weaker household demand due to inflationary pressures.”
‘Technical recession’
This, the strategist noted, could ultimately push default rates higher, although probably at a slower pace than the market believes. Furey assumes a technical recession, shorter and deeper than usual, with defaults rising to 3 percent, maybe 5 percent.
As a result, after a period of high prices for global high yield, with tight spreads of 300 basis points and all-in returns of 4 percent, investors are suddenly looking at a very different picture. “This looks like a rare opportunity to deploy capital, at strong expected returns in a single year,” he said.
In the US high yield market in particular, he said that with the current spread level of 600 basis points, it provides a buffer of about 250 basis points above the current level of defaults and recovery rates. “An excellent safety margin,” he said.
Meanwhile, given the high spreads, a lot of bad news is already priced into the category, he said. This makes the downside risks, as far as he is concerned,“not that big”
AllianceBernstein assumes a lower default rate - 2 percent for high yield in the US. According to the fund house, the weakest companies have already gone bust during the bankruptcy peak in October 2020, it writes in a contribution on analyst platform Seeking Alpha.
No time for bad habits
The firm said the surviving, strong companies have since had “too little time” to develop unhealthy financial habits, and noted that the corona crisis has also caused an increase in impaired investment grade bonds in the high yield index.
The quality of the high yield market is thus said to be at its highest level in ten years. According to the fund house, bonds with a BB rating currently make up 52 percent of the market, compared to an average of 46 percent over the past ten years.
Candoris also supports that view. The percentage of CCCs in the high yield index is currently smaller and the balance sheets in the BB/B class stronger on average compared to previous cycles, according to Dutch investment firm. “Less than about USD 100 billion of debt needs to be refinanced before the end of 2023.”
High Yield is in the best shape in decades, Candoris said, “after two cycles of high defaults and a shake out in commodity prices”.
Enthusiasm not shared widely
The enthusiasm is not yet shared in reports from the primary market. The market for new issues of high-yield bonds has almost come to a halt, according to Bloomberg data.
Meanwhile, more than three-quarters of S&P companies that published company figures revised downwards their earnings guidance, it emerged earlier this week. And, after initial inflows, there was a 650 million dollar outflow from US high yield funds last week.
This article originally was published on InvestmentOfficer.nl.