16 June 2023
What matters more to high yield: spread or yield?
The market continues to expect an economic slowdown, which should be negative for risk assets. Yet a question remains for investors, should they capitalise on the attractive all-in yields offered by the high yield market now or should they wait to pick up the pieces after a future sell-off?
A generally resilient first quarter earnings season has meant that aggregate European and US high yield credit metrics have remained solid despite rising borrowing costs. However, a range of macroeconomic factors, such as persistently high European food inflation and fading US small business optimism, create a more cloudy outlook for corporate fundamentals. At the same time, US and European loan officer surveys have shown a degree of tightening in lending standards that in the past has preceded impending recessions. While aggregated high yield credit metrics have yet to really budge, market implied funding costs have changed dramatically over the past year. Undoubtedly some high yield credits would be unable to cover higher interest costs on current earnings levels, let alone recessionary ones. In no industry segment is this refinancing risk more apparent than in the European real estate sector where borrowers cling to lofty asset values producing low rental yields that can no longer be justified. As a result, their rental income will be unable to cover their higher interest bills. Selected issuers in other industries will face similar problems when their turn comes to refinance. These risks aside, there is still the consolation for high yield investors that the starting point of credit quality is the strongest it has ever been heading into a potential economic slowdown. As such, our peak default expectations are no more than 3% for Europe and 4% for the US.
Both US and European high yield all-in spreads, measured by option adjusted spread (OAS), have been range-bound since late March, trading between 450 and 500 basis points (bps). When looking at numerous credit metrics, a very small tail of troubled names trade at distressed levels (i.e. OAS greater than 1,000bps). If we were to strip off the distressed parts of both markets, which make up 5.3%* for European high yield and 5.8%* for US high yield, spreads would trade fairly tight – roughly 300bps for Europe and 350bps in the US. However, the index yield to worst has remained remarkably stable at around 7.2%* (EHY) and 8.6%* (USHY). On a 10 year time horizon, yields are in their 96th percentile in Europe and 94th in the US. The benefit of this high level of carry is apparent in year to date returns and also should provide a good degree of downside protection if spreads re-widen.
Distressed credit level creeps above average but remains well below past peaks
Technicals remain a key support for valuations. While retail flows into European high yield funds have been modest at best this year and US high yield retail flows have recorded outflows, the market has continued to shrink. The combination of credits returning to investment grade (‘rising stars’) and the repayment of debt incurred during the pandemic have been the main contributors to a smaller market. Primary issuance, despite having picked up in both markets, has mostly refinanced existing debt, thereby adding little to net supply. Looking ahead, however, we expect a seasonal uplift in supply before the slower summer months and an increase in the amount of fallen angels compared to rising stars over the latter half of the year. This could soften undeniably strong high yield technical conditions.
What does this mean for investors?
While European and US all-in yields have remained close to their highest point of the past decade, thereby providing an attractive cushion against heightened risk aversion, we believe too little recession risk is priced into spreads. We suspect that monetary tightening will increase pressure on corporate profitability while heightening tail risks. Therefore, we think that spreads could widen from here and believe 600bps is a reasonable level to compensate for a recession/sharp sell-off scenario and are mindful that rates could help cushion the blow to returns. Thankfully, high carry and a possible rally in base rates under such a scenario should alleviate the impact of such spread widening on total returns. Whatever happens to spreads from here, avoiding high yield markets could be an expensive choice.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum