US High Yield – Risk On

We believe low default rates and robust fundamentals offer a compelling investment case for US high yield, underpinned by a strong economic backdrop.
Bryan Petermann

Portfolio Manager

Muzinich & Co

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With the behaviour of high yield bonds so closely linked to economic performance, US high yield has rebounded strongly over the last 12 months.1 While US high yield spreads have recovered to pre-pandemic levels (Fig. 3),  we believe the fundamental picture for the asset class remains compelling. This is especially the case if rates rise; high yield spreads can absorb rate moves more readily than higher-rated asset classes.

Fundamentals are also stronger because many companies have been extending debt maturity profiles, streamlining operations, managing inventory levels and proactively raising liquidity to weather the Covid-19 storm. As a result, the reopening of the US economy has led to strong cashflows and earnings for many companies. On the back of these events, we have seen declining leverage ratios, improving coverage ratios and stronger equity cushions.

Default rates have also fallen dramatically since last March and are at their lowest levels since before the great financial crisis (Fig. 1). Year to date, the default rate for high yield bonds and loans is just 0.65% for each market.2  A bullish outlook for economic growth over the next 18 months and a favourable year to date upgrade/downgrade ratio of 3-to-1 ratio, point to an overall positive outlook for US high yield credit. 3

Fig. 1 Default Rates Near Historic Lows

Source: JP Morgan Default Monitor. Data as of July 31st, 2021. For illustrative purposes only. Muzinich views and opinion for illustrative purposes only. Not to be construed as investment advice or an invitation to engage in any investment activity.

What about inflation? While we are seeing inflation pressure, which could impact profit margins, it is quite possible that this pressure may be transitory. We are already seeing corporates passing through higher costs to consumers. 4

There may be a change in this trend going into 2022, but for the remainder of the year we believe it is unlikely to be an issue. Another positive indicator is the rating migration of the asset class. The number of BB-rated bonds are at their highest level in over two decades at 54%, while CCC rated-bonds only comprise 11.6% of the index – a level not reached since June 1999 (Fig. 2).

The current rating profile of high yield is the best it has been in over 20 years, unlike other fixed income areas that have seen a downward migration in ratings. 5

Fig- 2 Breakdown of CCC and BB Rated Bonds as % of US High Yield Market

Source: ICE Index Platform, as of 31st August 2021. ICE BofA ML US Cash Pay High Yield Index (J0A0), ICE BofA ML CCC and Lower US Cash Pay High Yield Index (J0A3) and ICE BofA BB US Cash Pay High Yield Index (J0A1). For illustrative purposes only. Chart shows the face value of the J0A1 and J0A3 as a % of the face value of the J0A0, going back monthly for the past 20 years. Shaded areas represent recession periods. Indices selected as best available proxy to measure relative breakdown of rated bonds.

Looking ahead, we believe defaults are likely to remain benign and, with a low percentage of CCCs, the US high yield market is well positioned to participate in the economic recovery.

The economic environment appears robust, central banks remain supportive and public and private markets are open. While rates could rise if the economic recovery extends and the Federal Reserve begins to taper its asset purchase programme, we believe high yield is well positioned to absorb a move since spreads are still well above their 2007 low. US high yield is still poised to potentially perform well over the foreseeable future as it has during in previous expansions where, historically, long-term high yield investors have been rewarded at current spread levels (Fig. 3).

Source: ICE Index Platform, as of 31st August 2001 to 31st August 2021. ICE BofA ML US Cash Pay High Yield Index (J0A0). For illustrative purposes only.

1.ICE Index Platform ICE BofA ML US Cash Pay High Yield Index (J0A0) as of 31st August 2021
2.JP Morgan Default Monitor, 2nd August 2021
3.S&P Global Ratings – Default, Transition and Recovery, 20th August 2021
4.JP Morgan, August 2021 US Auto Sales, as of 2nd September 2021 
5.BofA Global Research, Bank to Work. Credit Market Strategist, 6th August 2021

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US High Yield – Risk On