By John M. Reed, Terry Ing Jun 08, 2023
In some countries, cars have warnings on their side mirrors: Objects may be closer than they appear. We believe that the high yield bond market may be cheaper on a risk-adjusted basis than it currently appears, too.
High yield option-adjusted spreads were at 450 basis points as of April 30, 2023, which is wider than on 61% of the trading days over the last 10 years. Yields, too, are more worthy of the term “high yield” than they have been since 2010. At 8.9%, they are higher than they have been on 95% of trading days over the last 10 years (Exhibit 1).
High Yield Bond Yields Are Elevated Compared to Long-Term Averages
However, these numbers don’t account for the improved quality of the high yield market. High yield issuers are larger than in the past, and bonds both carry higher ratings and are more likely to be secured. Fundamentals in the asset class look relatively solid for the most part. Adjusting for the lower risk of this higher quality market, we think option-adjusted spreads are actually quite compelling.
More than half of the high-yield benchmark is composed of BB-rated bonds as of early May 2023, compared to 29% at its lowest point in early 2001, and over 85% of the market is rated B or better (Exhibit 2).
High Yield Bonds Rated B Or Better
At the same time, the size of the firms issuing bonds has grown steadily over time. Size matters, as we have seen that larger companies generally tend to weather periods of volatility and economic uncertainty better than smaller companies. In the early 2000s, the EBITDA of the average high yield issuer was between $250 million-$300 million. In the fourth quarter of 2022, the average EBITDA reached $1 billion for the first time.
This change is not merely an artifact of issuers getting larger in general. Over the same period in the investment-grade markets, the average EBITDA has oscillated between $1.5 billion and $2 billion, excluding the extreme examples of tech megacaps.
We attribute the trend partly to migration. Smaller issuers had gradually begun to opt for the leveraged loan market over high yield. That shift reflects, in part, a preference to deal with one lender and forego the time and uncertainty of negotiating with a large group of potential high yield investors. However, the major force behind the change is a desire to avoid call protection, which prevents issuers from buying back their bonds and refinancing at a lower interest rate. Lately, with the CLO markets largely shut, these smaller issuers have been increasingly opting for private credit solutions. Firms with highly levered capital structures have had a similar shift, and those credits are now largely in leveraged loans and direct lending.
At 29% of the U.S. high yield market by par as of March 31, 2023, the concentration of secured bonds also stands at a record high (Exhibit 3). Secured bonds, backed by collateral, enjoy historical recovery rates of 55% vs. 40% for unsecured bonds in the event of a default. We think the proportion of secured bonds in high yield will continue to rise, as borrowers that may have once sought a leveraged loan tap the high yield market opportunistically. Banks have pulled back on lending, and CLO creation has slowed dramatically, making leveraged loans less readily available. Some borrowers may also prefer the fixed rates of high yield to the floating rates of leveraged in a higher-inflation environment.
% of HY Market that is Secured
But What about Fundamentals?
When recession risk is rising, many investors focus on overall risk. Certainly, the high yield market has its share of problem credits, but the stresses are dispersed relatively evenly compared to, say, the 2016 crash in oil prices, when fully 19% of high-yield energy issuers defaulted.1 The technology sector would be the next likely place to look for fault lines, but technology is a relatively small part of high yield bond issuance. However, the failure of Silicon Valley Bank, which loaned heavily to tech startups and did relatively little in the way of traditional banking, did show how even indirect exposure can affect a business.
Only a small proportion of high yield bonds mature this year and next, and the absence of refinancing pressure should keep idiosyncratic defaults from mushrooming into sectoral or even systematic stressors. Leverage levels are also at record lows, which should put less stress on borrowers.
Putting it all together, the high yield market has changed, and frameworks for evaluating risk and reward should change with it. The quality of the bonds is higher, debt is more likely to be secured by collateral, and leverage is low compared to history.
Defaults are clearly the elephant in the room heading into a likely recession, but we think that the larger companies and higher quality credits in the high yield universe will likely lead to lower volatility and a lower default rate than in the past. Recoveries are holding steady, too. With an average price of 87% of par now, downside risk is limited vs when bonds trade close to par. This reduction in downside risk coupled with the potential for price appreciation makes the ratio of return to risk more compelling.
A risk-adjusted reward that is likely more attractive than it appears could make high yield even more appealing to investors if the U.S. Federal Reserve begins to move away from a tightening stance later this year. In that event, capital allocators would likely appreciate even more the trifecta of improved credit quality, liquidity, and fixed interest rates.