By Cary Springfield, International Banker
According to the S&P U.S. High Yield Corporate Bond Index, US junk bonds returned 1.53 percent during July, bringing the total returns for the first seven months of the year to 6.7 percent. As such, US junk bonds have comfortably outperformed other segments of the US bond market—the Morningstar US Core Bond index, for example, returned only 2.1 percent during the same seven-month period. But with the US economic outlook still far from certain and the high-yield bond market itself experiencing considerable shrinkage this year, questions remain over the appeal of this asset class at present.
High-yield bonds constitute a sub-section of corporate bonds rated below BBB− or Baa3 by credit-rating agencies. Given the higher risk high-yield bonds represent to investors compared with government and high-grade corporate bonds, issuers must thus offer higher coupon rates to compensate for the likelihood of defaulting on their repayment obligations. Such issuers used to largely comprise “fallen angels”—investment-grade companies that had been downgraded below investment grade and had thus fallen into “junk” status. But since the 1980s, the high-yield market has grown to include a greater variety of new bonds from companies with below-investment-grade ratings, with more investors drawn to the market in search of yields and more issuers entering it to raise financing for a variety of corporate purposes.
With yields surging from under 4 percent in the third quarter of 2021 to around 9.5 percent in October 2022, junk bonds suffered alongside the rest of the US bond market complex as prices dropped to historical lows. With the Federal Reserve (the Fed) hiking interest rates aggressively throughout much of last year to send borrowing costs skyward, moreover, US high-yield bond issuances crashed to a 14-year low. According to Dealogic figures, full-year corporate high-yield issuances in 2022 dropped to $91 billion from $404 billion a year earlier, while PitchBook noted that bond issuances during the second half of last year were at their weakest point since the Global Financial Crisis (GFC), with a cumulative $34.3-billion total of high-yield bonds being issued during the six-month period.
Yields eased this year, however, to 8.2 percent by early August as demand for junk bonds moderately recovered; nonetheless, they remain historically high. A recovery in high-yield bond issuances is also underway, with the second quarter recording more than double the issuance numbers compared to a year earlier and issuances in April and May marking the best two-month sequential total ($40 billion) since the final months of 2021. That said, PitchBook described this year’s growth as moderate by historical standards.
Nonetheless, the stellar gains for junk-bond investors this year can partly be explained by growing market expectations that a soft landing for the US economy can be engineered as inflation continues to cool and negative growth has yet to materialise. “In this environment, high-yield rallied across the board. Returns on BB bonds were suppressed by a modest increase in US Treasury yields, while CCC bonds performed the best, based on the soft-landing outlook,” Nomura Corporate Research and Asset Management’s chief executive officer, David Crall, wrote for the firm’s early-August assessment of the market, pointing to disinflation in important categories—such as energy, autos and rents—slowing headline inflation and the Core Consumer Price Index (CPI) and broadly stable employment data as explanatory factors. “We maintain a positive outlook for the remainder of the year, though continued validation of soft-landing expectations will be important to market performance.”
By early August, the 3.80-percent spread on junk bonds over 10-year US-government Treasuries was almost 2 percent tighter than it was a year ago, thus strongly indicating that more investors are expecting brighter times ahead and that the Federal Reserve can rein in inflation without unleashing excessive economic pain. For experienced observers, such as Marty Fridson, chief investment officer at investment firm Lehmann, Livian, Fridson Advisors, such trends “are an ongoing mystery”. Speaking to the Financial Times in June, Fridson claimed there was “really no evidence” of the market pricing in a US recession. “Issuers really have the upper hand. They don’t have large portions of their debt coming due within the next year or two and are not facing an actual need to refinance.”
Perhaps the strengths of the balance sheets of participating issuer companies provide some evidence to justify this ongoing bullishness. “Global high-yield bonds continue to look attractive given robust corporate fundamentals and yields that are around their highest levels in many years. Corporate balance sheets are relatively healthy as many companies secured low‑cost funding in 2020 and 2021, and this could help keep default rates low this year despite economic growth slowing,” Mike Della Vedova, co‑portfolio manager of the Global High Income Bond Fund at T. Rowe Price, noted on July 10. “The need for new issuance in 2023 is likely to be low, which is also supportive. These factors should sustain the asset class despite the potential for volatility driven by sticky inflation, slowing growth, and banking sector worries.”
According to Manuel Hayes, senior portfolio manager at London-based asset manager Insight Investment, moreover, the rate of defaults for junk bonds in the broad US high-yield index stands at just 1 percent this year, much lower than expectations of 5 percent to 8 percent at the beginning of the year. “Default rates even in the worst-case scenario of a prolonged high-rate environment are now expected to tick up to about 2-3 percent with a lot of this risk priced in already,” Hayes told Reuters on August 11.
Such resilience among high-yield issuers can be explained by prudent balance-sheet and liquidity management to boost profitability during the pandemic, AllianceBernstein explained, adding that many of the weakest issuers were already “weeded out” when high-yield defaults peaked at 6.3 percent in October 2020. “That was less than three years ago. Since then, there simply hasn’t been enough time for the survivors to develop unhealthy financial habits,” the asset-management firm noted in their analysis published on July 28. “What’s more, some defaulted bonds were replaced by those from the lowest-rated investment-grade bonds that fell into the high-yield market. These ‘fallen angels’ helped to raise overall index credit quality. Today, BB-rated bonds—the highest high-yield rating—make up 49 percent of the market, compared to 43 percent on average over the past 20 years.”
A flurry of rating upgrades to boost the profiles of high-yield issuers might also explain recent junk-bond strength. According to Goldman Sachs, more than $81 billion of debt reached investment-grade status by late June, compared with a total of $116 billion for 2022 in its entirety. Only $15.6 billion of debt had been downgraded to junk status, the bank added. Indeed, the resulting supply shrinkage of junk bonds this year has been “entirely driven by rising stars exceeding fallen angels”, according to Lotfi Karoui, Goldman’s chief credit strategist, with more recent upgrades reflecting a “backlog essentially of rising star candidates that should have probably been upgraded in late 2020, mid-2021”.
But some believe that current metrics do not reflect the health of the US economy. A July 12 Financial Times report found that the $1.35-trillion US junk-bond market had shrunk by almost $200 billion since its late-2021 peak, raising prices but also giving overly optimistic signals regarding the US economic outlook. And with Dealogic figures showing only $20.4 billion—less than one-third of total junk issuances—being used for new fundraising this year through May, the US junk-bond market could be painting a deceptive picture of economic prospects. “The vast majority of supply that has hit the market this year has been deployed towards refinancing—and so you’re not really adding more debt on balance sheets, you’re just replacing the old debt,” Goldman’s Karoui stated.
But should a deep recession transpire, high-yield bonds could suffer greatly as investors dispose of the riskier parts of their portfolios, with yields skyrocketing into double-digit territory. “I view the high-yield asset class, especially double-Bs, [as] fairly vulnerable if we do move into a recession that’s not just a very minor and shallow and brief recession,” Adam D. Abbas, co-head of fixed income at Harris Associates, told the Financial Times in July.
“If economic growth plateaus over the next 12 months, we’d expect Treasury yields to hold steady and spreads to tighten slightly. But our base-case scenario—and one that’s becoming increasingly the consensus—calls for a soft landing, which would likely result in modestly lower Treasury yields, modestly wider spreads and mid-single-digit returns over the next 12 months,” AllianceBernstein noted in its August 8 analysis. “It would take a hard landing and a dramatic widening of spreads to drive high-yield returns into negative territory. That scenario is least likely, in our analysis.”