High-yield US debt rallied early in the fourth quarter on higher-than-expected corporate earnings numbers and signs that the Federal Reserve may slow the pace of rate hikes as inflation slows.
Reduced volume of new issuance reduced supply and capital inflows into the sector also supported the asset class. Although the Fed’s speech halted the market’s rally towards the end of the quarter, the Bloomberg US Corporate High Yield returned 4.2%, down 11.2% year over year.
The total return registered by high-yield debt in 2022 has been the second worst in its history, behind that registered during the global financial crisis of 2008 (-25.9%). High-yield debt has never delivered a negative return for two years in a row. Furthermore, historically, the asset class has delivered a strong average annual return after a year of negative performance. However, investors are advised to remain cautious regarding the asset class.
The market has already priced in concerns about a slowdown in the global economy and the universe of distressed debt has moved closer to its historical averages. In turn, it is expected that defaults will also reach their historical averages in the next 12 to 24 months. Not all distressed bonds will default, providing a conducive environment for stock selection.
Corporate earnings growth has slowed, although fundamentals remain largely intact. Gross leverage remains below pre-Covid levels, and debt service capacity is high as many companies refinanced when rates were low.
Leverage and interest coverage ratios remain strong, but could weaken if the economy were to enter a recession. However, the credit quality of the sector is today higher than in previous recessions.
Capital inflows have slowed after the strong start to the quarter. The volume of flows has been concentrated in ETFs, which points to a tactical strategy and not to long-term trend changes in the asset allocation of individual or institutional clients. Although there is a balance between technical supply and demand factors, the reduced volume of near-maturity debt could favor the supply segment for at least the next twelve months.
Optimism about the market is supported by the sector’s relatively short duration, with an opening yield close to 9.0% and spreads close to their historical medians. Earnings figures over the next two quarters will have a strong impact on idiosyncratic price movements, providing a favorable environment for managers to create value through stock selection.
US high-yield spreads could rise as economy slows
Increased distressed debt. Defaults could also rise
