What the Fed’s rate cut means for US high yield

The US high yield (HY) market reacted positively to the 50 basis points (‘bps’) rate cut delivered by the US Federal Reserve (Fed) in September.  Spreads are 6bps tighter today versus 17 September (prior to the Fed’s announcement), and as of 25 September, month-to-date and year-to-date performance for US HY stands at 1.4% and 7.8%, respectively ¹ . In comparison to the volatility seen at the start of August on the back of the US payrolls miss, the reaction was relatively muted across the credit spectrum following the Fed’s decision.

Attention now turns to the balance of risks for the Fed, notably around the labor market, but for the HY asset class the current trajectory of low but positive GDP growth is historically the sweet spot, allowing HY companies enough room to grow EBITDA and revenues without the headwinds of a full-blown recession, or at the other extreme, the excesses that tend to come with a much stronger growth environment.

For the majority of US HY companies and their ability to service interest expense, the fact that the Fed has just got the ball rolling in terms of easing is the most important factor, not necessarily the size of the move. However, for a much smaller tail of HY companies, particularly certain capital structures in sectors like Telecom, Media and Healthcare, who were already struggling with high debt burdens and too much leverage, the 50bps cut is much more significant.

Some of these larger capital structures are also currently benefiting from other positive tailwinds in the form of announced or rumored M&A headlines and positive recent earnings momentum. This has given relief to some of the more distressed names in the market, leading to strong contributions to the recent US HY market return from these issuers. 

Value traps emerge

Spreads have remained largely static over the near term around 320-350bps and are tight by historic standards. We continue to see dispersion across industries and issuers, as the impact of a slowing economy and higher financing costs have been felt at different times, but the rates move since April has, to an extent, muted the distinction between ‘performing’ and ‘non-performing’ companies.

This is reflected in the amount of spread compression experienced by the higher yielding part of the US HY market with the percentage of the market yielding 8%+ declining from 24% in April to 15% today. Meanwhile, the percentage of the market yielding 5-6% has grown from 0.3% in April to 27% today ² . The fact that a very small percentage of the overall US HY market trades around its average YTW (currently ~7%) highlights the potential value traps that these moves have created.

Other industry trends

We continue to observe a recovery in parts of the HY market, such as Basic Industry/Chemicals, that already felt the full effects of a slowing economy last year. Meanwhile, certain consumer facing industries, particularly those more dependent on the lower income consumer, are now showing some signs of weakening. Revenue guidance is coming down from many Retail/Consumer Product companies for H2 2024 as larger retailers such as Walmart, who can command greater price promotion, start to outperform.

However, the story is not all bad for the consumer, with the higher income consumer seemingly doing fine. The Las Vegas strip continues to remain resilient, with both gaming and hotel businesses maintaining steady growth, despite facing difficult competition and much higher room prices. Parts of Leisure, particularly cruiselines, are holding up well, showing that demand for their products has continued to remain resilient in the post Covid era.

Outlook

The evolution of the US HY market this year so far can be split broadly into two phases. First, the start of the year to April was mainly a carry trade as rates moved higher, with the market refocused on the strength of the economic data and stickiness of core inflation. This period was underpinned by a non-uniform US economy and diverging industry and idiosyncratic issuer trends, which created a lot of dispersion in the market. Second, the period from ‘peak rates’ in April up to the Fed’s September rate cut has been dominated much more by the move lower in the 10-year Treasury by ~100bps, which has provided a positive tailwind for all fixed income inclusive of HY. The market has now increased the chances of another 75bps of easing by year-end to 70%, from 30% before the meeting. We consider the pace of Fed cuts as more significant than the ultimate terminal rate in determining what happens across US high yield capital structures.

Overall, technicals continue to be a key driver of positive performance in high yield. Alongside this, HY continues to benefit from robust fundamentals across the broad US HY market. This is highlighted by the continued decline in the HY bond default rate to 1.7% including distressed exchanges or 1.0% excluding distressed exchanges as of the end of August - a 20-month low.³  Add to this the fact that the number of rising stars continue to outpace fallen angels in 2024⁴  and the number of high yield issuers upgraded in August exceeded downgrades for the fifth consecutive month suggests that credit momentum remains strong.