The terrible twos

· By Jack Holmes, Artemis’ fixed income manager

sábado 07 de enero de 2023, 10:49h
Jack Holmes, Artemis’ fixed income manager.
Jack Holmes, Artemis’ fixed income manager.

2022 was a tough year for the high yield market as the stickiness of inflationary pressures became apparent and central banks rushed to tighten monetary conditions. European high yield had the additional pressure of an energy crisis and worries around gas shortages over the winter period.

The pain felt across markets in 2022 has resulted in a complete reset of valuations within the high yield market. At the lows in yield seen in 2021, US high yield yielded just 3.8%. As I write this (19/12/2022), the market yields 8.3%. This places the market within the widest 10% of observations in the post-2009 period. Within high yield, valuations have moved a lot over 2022 and this places us in a much healthier position for long-term returns going into 2023.

Of course, we do also need to consider the fact that we are likely going to have an increase in defaults from the very low levels seen in 2022. However, I believe there are many reasons why we can feel comfortable that this default cycle will not be as bad as previous cycle experiences.

Firstly, high yield has never been higher quality going into a recession than it is today. The share of BBs in the market – the highest quality part of the high yield market – was 40% going into 2008. CCCs – the riskiest part of the market – made up 17% of the market. Today, BBs make up 58% of the market and CCCs make up 9%. When you consider that the median annual default rate is 0.6% for BBs and 25% for CCCs, this move up in quality really shines through.

Secondly, companies have spent the last few years of very low level yields refinancing and extending maturities. Just 2% of the total US High Yield market is set to need repaying in 2023, and more than half of these bonds are BBs – companies that typically have plenty of resources on hand to repay maturities with cash. So, the usual worries about maturity walls don’t appear to be a significant issue for the high yield market over 2023.

The third point is something of a double-edged sword. Companies who borrow money (which obviously includes all the high yield market!) will need to pay more for this borrowed money over the coming years. A small minority of issuers will struggle with this situation to the extent that they are forced to default. However, the majority that survive will be faced with a much greater incentive to reduce leverage and interest costs by paying off debt and improving their credit quality. So effectively – while a small minority of companies will default because of higher rates, the majority that survive are likely to have far greater pressure to improve credit quality. Being on the right side of this – by avoiding the defaulters and benefitting from the credit improvement in the survivors – will likely drive significant total and relative returns over the coming years.

Death and taxes (and volatility)

Outlooks always present a simplified and concise version of the coming year and can sometimes give an impression of a certain route along a very straight road. We know that this is not reality. While 2023 is starting with high yields and a position of strength from a credit quality perspective, markets do not move in straight lines. We are likely to have volatility in 2023 as we continue to grapple with the interplay between inflation, central banks, and economic performance.

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