US High Yield Market Update

US High Yield Trading Comments (stats as of 6/20/23)

• June has seen a broad-based rally in risk assets (High Yield +1.54%, S&P +5.1%, Russell 2000 Index +6.8%) on the back of a generally positive earnings season, revised inflation expectations with healthier than expected economic releases.
• High Yield (HY) flows turned positive in June after lawmakers found a constructive resolution to the debt ceiling debate in late May with over $3 billion entering the market.
• The primary theme for the last few weeks has been strong compression between the higher and lower quality parts of the market. BB / CCC at a spread of approximately 700bps is at a YTD tight.
• HY continues to benefit technically from upgrades as the most recent, OXY, officially entered the investment grade index at the beginning of June. OXY boosts year-to-date (YTD) rising star volume to $59 billion, exceeding the $1.4 billion of fallen angels YTD.
• Overall trading volumes have waned year-over-year (YOY) but liquidity in the market remains healthy as buyers continue to emerge on any perceived market weakness.
• The primary market has priced approximately $87 billion notional to date, a 30% YOY increase, with the majority of the issuance going towards refinancing opportunities. Most deals stuck on dealer balance sheets from last year have cleared as well, leaving them in a better position to assist with financing.  As previously noted, limited net new issuance continues to provide a strong tailwind for HY.
• Federal Reserve policy meetings and subsequent rate decisions remain a key focus for credit markets as do economic indicators tied to inflationary trends and employment data.

US High Yield Research Comments

• We continue to observe relatively solid balance sheets and corporate fundamentals across the overall HY market, and the overall leverage of the market declined in 1Q22 to 3.9x. However, we continue to see diverging HY trends in quarterly results.
• The overall market has begun to see a decline in the average coverage ratio, as expected. This coverage ratio is expected to decline with rising rates and softer cashflows, but we do not expect to see such drastic declines as in other markets across US leveraged finance.
• For context, the HY coverage ratio has remained above 5x in each of the last six quarters having not done since at least 2008 (long-term average excluding last six quarters is 4.35x).
• Moreover, most HY bond issuers have had a lot of time to adjust to this higher rate environment. However, in other credit markets such as leveraged loans, the rise in interest cost is having a more immediate impact on issuers and is leading to more distressed situations.
• While receiving higher coupon payments is rewarding to investors, investors need to be even more cautious in analysing which issuers can manage this increase in interest rates. In addition, investors will need to weigh the decision on the current higher income streams of floating rate markets with less call protection (private debt / loans) vs locking in yields with lower dollar price bonds with better call protection or convexity (HY / IG).
• For the HY bond market specifically, we remain cautious on companies which have a large percentage of loans (i.e., floating rate) exposure in their capital structure. In the HY bond market, only about one-third of companies have loan exposure, which all ties in with why the coverage ratio for HY issuers remains high.
• There appears to be many great opportunities across all credit markets today. Ultimately, we believe the key to success in investing in these credit markets is focusing on companies with a high free cash flow generation that can absorb higher interest rates.

Glossary:

Rising star: high yield bond that has the potential to become an investment grade bond due to improvements in the issuing company’s credit rating.

Fallen angel: Bonds that were investment grade and are now rated as high yield due to a reduction in the issuing company’s credit rating.

References to companies and sector are for illustrative purposes only and should not be viewed as investment recommendations.