Assessing the Opportunities & Risks in High Yield Today
Greg Campion: Fixed income markets have shined thus far in 2023 with strong performances in investment grade, corporate credit, structured credit, and high yield bonds and loans to name a few, but with a potential recession on the horizon and concerns that credit spreads are trading toward the tighter end of historical averages, can this strength, particularly in the high yield markets continue?
Scott Roth: So with yields in excess of 8.5% for bonds and 10% for loans, we still think it's a very attractive time to be allocated to high yield. History has actually shown that high yield tends to perform well at the end of raid cycles and even in modest recessionary periods.
Greg Campion: That was Scott Roth, co- head of Global High Yield at Barings, and this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on the show, assessing the opportunities and risks in today's high yield markets. All right, Scott Roth, welcome back to Streaming Income.
Scott Roth: Hey Greg, thanks for having me. It's great to be back.
Greg Campion: Yeah, excited to have you back. I was thinking back to when you were on the podcast last time, and it was almost exactly a year ago, September 22. And at that time it was a much different environment. We were looking at a much tougher year for high yield and risk assets more generally. This year, no shortage of stuff to worry about, which I'm sure we will get into, but all things considered has been a pretty good year for high yield and floating rate loans, knock on wood. Now, just curious, maybe to start there, what's kind of gone right for high yield so far this year?
Scott Roth: Well, you're right, it's been a good year for high yield for sure, loans and bonds, both on an absolute as well as a relative basis compared to some of the other credit or fixed income asset classes. And look, I think there's been a number of factors that have contributed to this level of performance. We can start with the economy. We've had a super resilient consumer really benefiting from this robust job market, and importantly, employees who have seen real wage growth this year on the back of some of these receding inflationary pressures. I think we're all aware of the phenomenon around the excess savings and how that's supported consumer spending. And I think there's been a level of stealth stimulus that's worked its way into the economy, and if you sort of roll that up and combine it with some of the disinflationary trends we've seen, I think the market has sort of come around and adopted this soft- landing narrative as the most probable outcome for the economy going forward. So that's been a huge factor. I would say corporate earnings, I would put that in the positive category as well, despite the fact that earnings have been negative on a year- over- year basis for the last three quarters. However, starting in the fourth quarter, companies have been able to jump over that lower hurdle that has been set. So you didn't go into this downward spiral, so three quarters down year- over- year, but better than expectations. And now we've reached a point in the back half of this year where earnings are expected to influx, so higher year- over- year. And I think what's really driving that has been corporate pricing power, and we know the strength that exists in the services side of the economy, the demand is very high. Companies are able to push through price that is really help support the nominal revenue and also protect margins at the same time. And then maybe the last factor I'll just bring up is default expectations. We came into the year, there were a lot of just dower or aggressive projections being put forward by some of the street strategists and they made for really good headlines, they have not really materialized. And I think a lot of these projections were really driven by more of a macro model versus a bottoms up, which is how we tend to look at it. And so we had difficulty reconciling that disparity. As it will turn out, we'll see in 2023, default rates are going to look very normal on a historical basis, so that's allowed spreads to compress over the course of this year. Rates have risen against that, but compared to some of the other fixed income alternatives that have lower coupon, higher duration, high yield has fared quite well.
Greg Campion: Yeah, you mentioned the rates, so maybe let's get into that. So obviously there's been a ton of talk lately about what the Fed's doing, where they go next for the rest of this year, for 2024, et cetera. There's been all kinds of opinions out there. It looks like the most recent commentary that we've gotten from the Fed kind of starts to put the higher for longer scenario, more cement that more into place. And it seems like maybe that's almost been a little bit non- consensus in that I think the market had gotten a little bit comfortable anticipating that we're at peak rate or close to peak rate and the next move is lower. So let me ask you that, what are the implications potentially for high yield if the Fed is not done hiking?
Scott Roth: Right. So that would be a pretty unhelpful development. Now that's not our base case. I think we're still of the belief that the disinflationary trend will continue to see that over the medium term. Acknowledging the fact that inflation tends to be wavy over time and we're starting to see that a little bit right now. But we do think as long as the Fed stays its course that they'll ultimately be able to achieve at least a good portion of what they've articulated to the market. Now, to answer your question, are we talking about a single rate hike? I think the market would be fine being able to absorb that. Conversely, if we're talking about the Fed having to engage in a series of rate hikes, that I think you are clearly looking at a resetting of risk in the market and there's probably some level of distinction that needs to be made. Loans versus bonds, loans are advantage with the floating rate nature and as rates go up, you see a corresponding increase in the coupon. So that would partially mitigate a negative outcome on that front. High yield bonds clearly fixed in nature. That's going to be a negative headwind for that. But I think the bigger picture on that front is you start to introduce a hard landing scenario and ultimately resetting default expectations higher. Look, I think there's probably some nuance around the origin of the rate hikes. What is driving the re- acceleration of inflation? If you're talking about more of a stagflation type environment, I think that's different than a situation where the economy is actually reaccelerating that no landing scenario, if you will, where the neutral rate we could argue would be ultimately higher than most of us believe it is today. So I think in those types of scenarios, there are different winners and losers. However, I think that's sort of an interim play. I think at the end of the day the Fed will have to sort of run down inflation with these rate hikes. Ultimately that's going to have negative consequences for just risk assets in general.
Greg Campion: All right. So you mentioned that your base case is not necessarily that the Fed keeps on hiking here. So let's assume the flip side of that coin. So let's assume that we're close to peak. Let's say we're either at peak rate here or maybe there's one more hike, and then the next move, whatever that pace looks like. So it seems like the concept of rate cuts in 24 has maybe gotten pushed out a little bit most recently, but let's say we're kind of there, rates don't go much higher, if higher at all from here and they start to drift lower, let's say, over the next call it one to two years. How does that scenario look to you from a high yield perspective?
Scott Roth: Right. We provide a pretty favorable backdrop to the market. History suggests high yield would do real well under that type of scenario. And we do have some history. If you just think back over the past 30 years, there's been four rate cycles, and 12- month forward returns following the last FOMC rate hike produces a return on average that's low double digits. I think the number is actually 12%. So if we are indeed at the tail end of rate hikes here, we think that's a fairly good setup here for the asset class going forward.
Greg Campion: So that's stat that you mentioned there I think would actually surprise some people. I think there's probably a perception out there that high yield, since you're taking credit risk when the economy starts to slow down, that would be a much tougher environment. So I think some might be surprised to hear that from peak rate and starting to move lower, returns have been quite healthy from there. So just tell me a little bit more about that and just how you think about high yield performance in more kind of recessionary periods.
Scott Roth: Yeah, so I think the key for this particular period is if the Fed can actually preemptively cut raise before you begin to impact the labor market. And if the Fed can effectively do that, which the market is beginning to embrace here, we do think that's a really good setup for high yield because you have inflation coming down, but the economy, even in a low growth scenario, you have spread compression at this point. You'd have rates coming in and all that would be really constructive for the total return aspect of high yield. Now there's another angle to this and that the Fed is not successful with a soft- landing scenario. And so how would high yield play out in that circumstance? And we do think there's a probability that that occurs. Ultimately, we think even if there's a mild recession, there are some defensive elements within the asset class right now that I think would be supportive. We always like to look at how an asset class will perform or what's the setup in a 0% return or a breakeven. And given that high yield's trading at a pretty significant discount to par right now, it's in priced in the 80s, which is typically associated with recessionary levels. If you have a situation where spreads back up, the prices will go down. But given the fact that it's such a short duration asset class inside of four years, you're effectively spring loading this. And so we don't think there's any real excess imbalances that exist in the economy. High yield has shown its ability to perform pretty well in low growth, no growth, and even slightly negative growth. We've seen a lot of that in Europe over the past decade. So we think the setup that high keeled can manage through a slower economic environment and do quite well.
Greg Campion: It seems like we've seen almost like a regime change in that the term ZIRP or a zero- interest rates into perpetuity is sort of becoming a distant memory at this stage. And we're all getting used to saying things like hire for longer, now that has material implications for asset allocation decisions that our clients need to be making in terms of how they're shaping their own portfolios. One of those is looking at equities versus fixed income. And I'd say based on a number of the conversations that I know that our teammates at Barings have had with clients and consultants, it seems like more and more of these conversations are coming up around allocation shifts out of equities into high yield. How are you thinking about that broad equity versus fixed income, or maybe even more specific equity versus high yield kind of trade at the moment?
Scott Roth: I think we're entering a pretty unique period here for fixed income, high yield included. And I mean that in a positive way. We just went through this process of resetting rates over the past, let's say 18 months, and it's been a painful process. Anything if you're associated with fixed income in 2022, you were down double digits. If you look at high yield over the past, let's say five years, in that low interest rate environment that you just highlighted, returns have been low single digits, so pretty poultry returns. So I think you've gone through a bit of this, just call it a giant reset, if you will. And I think what you're left with is a market that more closely resembles a traditional high yield market with yields in that eight to 10% context, which again, if you think about forward- looking returns when you're at those yield levels, they tend to be quite attractive. And high yield has some unique characteristics right now, such as the discount to par north of 10 points. You have duration, which is short, less than four years. Those are defensive elements in a more downside scenario. So you compare that with equities, and equities have had a very strong run in the face of declining earnings. So everything's been multiple expansion. And on top of that, it's taken place in a rising rate environment. So we're at a situation where multiple or valuations are very ambitious on the equity side right now. And I think just stepping back, I think our clients are looking at that, those valuation metrics, and they have a menu of options over here now with this normalization of rates that we're going through in a variety of fixed income products. And I think many of those have some level of durability in more downside scenarios, and they're looking to reallocate. We're seeing that if you think about pension funds, that's a big client base of ours. Funding status on pension funds are at the highest level in many cases since 2007. So they're looking to potentially take some volatility out of their book and move it over to areas in the fixed income landscape where we haven't seen yields at this level in some time.
Greg Campion: Let's just dig into that a minute because you talked about potentially taking some volatility out of your portfolio by shifting out of equities into an asset class like high yield. Somebody may be listening to this saying, " Yeah, but it's high yield." By its nature, it's a risky investment in terms of the credit risk that you're taking on. How are you thinking about that kind of quality of the market today or general risk that folks are taking on by investing in high yield today?
Scott Roth: Yeah, I think one thing that investors really need to appreciate is that the quality of the high yield market today is the best it's been in the history of high yield. And I'm talking from a ratings' composition basis, but also from the fact that most of these companies are larger and more diversified across the globe than they've ever been. And the majority of issuers today are BB rated. And so that's a seismic shift from only a few years ago. The lowest rated quality band is triple C, that's 9% of the market today. That was 10 to 15 years ago, 100% higher than it is today. So the fundamental shift across high yield is very different. You have very branded companies that you wouldn't even realize operate in the high yield space. So there's not this stigma that's associated with this market that there might've been 20 years ago. So we think the quality of the market has to be a consideration, and especially when you're comparing high yield spreads in a historical context, so you have to make that adjustment. And so we think it's a market where BBs that are yielding 7.5% with, in my opinion, almost a default risk that is nil. It's a pretty compelling situation right now.
Greg Campion: High yield is a market where technicals can play a big role, applied demand, characteristics. I know certainly for the loan market, CLO demand plays a big role. You've got inflows and outflows out of the asset class. If you were to kind of just broadly summarize what you're seeing from a market technical standpoint today, what would you say?
Scott Roth: Technicals are quite robust right now. In 2022, Rising Stars are simply high yield rated companies that due to improving fundamentals, the rating agencies upgrade them to investment grade. That was a record year in 2022, followed by another very strong year in 2023, it might end up being the second highest on record. And as those companies migrate to investment grade, those dollars get recycled back into the high yield market. So you have a shrinking market where there's more dollars chasing it. So you have this supply, demand imbalance. You could argue that the market is actually been undersupplied this year, because if you look at the primary market, it's been very muted, and all the issuance or the majority of the issuance, roughly 75% across loans and bonds has been used for refinancing activities. The M& A market is down roughly 40% year- over- year after arguably a very lackluster 2022. So it had very easy comps. So there's really no new net supply that's finding its way into the market, and that's created a very strong technical across high yield bonds and loans. And even as we look forward, the pipeline is pretty shallow here. So we think this technicals are going to be with us for some time until actually the M&A market begins to rebound. And look, the maturity wall continues to get work down with these levels of refinancings, and really what's left here over the next 18, 24 months. Primarily BB credits, and these are companies that have access to the capital markets, the CFOs of these companies, like their low coupons a lot. So they're loathed to pull those things out prematurely and place higher coupon debt in their place. So we don't see a real surge of issuance in the near term.
Greg Campion: Another trend that we're seeing, and this one's more I would say a structural trend, is the growth of the private credit market. So it's hard to sort of ignore what's happening there. Obviously our colleagues here at Barings are a big part of that. I'm curious, we've seen headlines of private credits encroaching on this part of the broadly syndicated market or taking down this big deal that would have in the past been a syndicated deal. Is that in your mind, managing high yield bond, loan portfolios on a day- to- day basis? Is that noise or is that a factor that's actually impacting your investment universe and you need to think about day- to- day?
Scott Roth: Yeah, look, this has garnered a lot of headlines, and I think we're all aware of the capital that's been committed to private credit. I think private credit has been hampered a bit in their ability to put those dollars to work in their traditional market. And so they've looked to deploy these dollars in alternative channels or adjacent markets, namely the broadly syndicated loan market. And so we've seen some level of encroachment on the edges really with some existing structures that have needed to be refinanced. And the most notable one recently has been a company called Finastra. Finastra is a very large software company. It's also highly levered, and in the public market, it had a very standard first lien, second lien structure. The problem was given its leverage profile, the ability to extend maturities or refinance in a regular way. And that was compounded by the fact that the investor base here is majority of the investors here are CLOs, and each CLO is at a different stage in its lifecycle. So their ability to extend at some level could be challenged. And so the structure had some overall challenges, and private credit shows up at the door with$ 5 to$ 6 billion of an all first lien structure to refinance that, and the equity sponsor elected to go in that direction. Now clearly lines are being blurred here. I think this can be and probably will be a prevailing theme here over the near term as we continue to sort of work on this maturity wall. I'd say in the interim period right now, this is a positive technical for the public loan market, just as I highlighted with the high yield market and rising stars, you have dollars coming out, those dollars are getting recycled back in to a smaller marketplace, creating a level of excess demand. And so on the issue of disintermediation, we've seen that before across asset classes, and there's ebbs and flows over time, and has happened to the broadly syndicated market before global financial crisis 2009. The loan market was effectively closed. So sponsors, companies, access the high- yield bond market, specifically the senior secured bond market to garner capital, refinance their capital structures, et cetera. They had to pay up, they had to pay a price to access that capital. But that happened and the markets continued to coexist. And the outlook is really favorable for the broadly syndicated market as it is for private credit, sponsors continue to view the broadly syndicated market as an attractive area to finance, and that will continue to be the case going forward.
Greg Campion: Yeah, I think that's the parallel that you draw with developments in the broadly syndicated loan market back in the financial crisis. Really interesting kind of a reminder that these things do tend to ebb and flow. I mean, obviously we're going through this what could be called a private credit craze right now. I think. Funny enough, my next guest on this podcast is Ian Fowler, so we'll be diving into some of the nuances there. But I think it is a very interesting dynamic. I mean, it's interesting to hear that maybe there's even a bit of a short- term tailwind for the broadly syndicated market, but it'll be a trend to walk to continue to watch in the years to come. We've talked a little bit about some of the dynamics impacting high- yield markets today. It's clear to me that there's a lot of attractions to this market today. I think the points you make around credit quality and how that's changed over time are really strong. And obviously there's no arguing with where yields are currently. So there's a lot of attractions there, but certainly there's risks as well. So if you were to summarize, what are the things to use a cliche that keep you up at night, what would those be?
Scott Roth: Well, we've mentioned one of them. I think that's at the forefront right now, the high yield market, and that's this idea of inflation reaccelerating from here. As I said, it's not our base case. We don't expect that to happen, but to the extent that you see that evolve and materialize in a bigger way, introducing the idea of stagflation. I talked about how the companies have been able to exhibit this level of pricing power in today's market. And if you have growth that becomes more subdued, that could be real problematic on the margin side, and you could see that ultimately hit corporate profits. As it stands right now, that's not what we see playing out, but that could be more of an issue for 2024 for the markets. I think anytime you're in the midst of a rate cycle, you have to be cognizant of a policy error. And I think the market's given the Fed a lot of credit thus far, but nailing that soft- landing can be pretty tricky, especially if you have inflation that is exhibiting this wavy behavior. And to be able to do that without impacting the labor market is something that can be tenuous. And so I think that's something that's on the table as well. There's always geopolitical issues that are lurking around the corner that can surprise you.
Greg Campion: Yeah, trying to orchestrate a soft- landing is no easy task. It's basically only been done once in the post- World War II era, which would be in the mid'90s when it was orchestrated well. But when it was orchestrated, it led to perhaps one of the best periods of economic growth that this country's ever seen in the mid to late'90s. So when it's done well, it can work, but it's a tricky path.
Scott Roth: Well, look, it would be unique in the sense that we would effectively be starting or renewing a cycle with employment, almost consider it full employment, and that would be something that we haven't seen before. So in some facets, we would be covering out new territory with this.
Greg Campion: You mentioned geopolitical risks. We haven't talked about a whole lot outside the US necessarily in this conversation, but we might be remiss not to mention that there's a lot of concern around China at the moment. Is that economy slowing down a lot of focus on the real estate sector there? Anything you want to mention as it relates to your day- to- day management of these portfolios?
Scott Roth: Look, I think the risks around China at this point are well- known. The piecemeal stimulus that's come out of the government has disappointed. The market is disappointed. Investors, the economy continues just be so sluggish. I think there is possibly a silver lining associated with China in the sense that had they introduced a more bazooka style stimulus that the market was quite frankly hoping for, that could have really led to this exporting of inflation across the globe. Think of energy prices where they're at today. If we think of really robust demand coming out of China, we could be looking at base metals prices, energy prices a lot higher. And so I think while it's been a difficult situation over there with that economy, we might be gaining a benefit off of this as well.
Greg Campion: All right, Scott, I think you've managed to give us a very realistic and balanced view of what's going on in high yield markets today, where some of the opportunities are, where some of the risks are. Let me ask you to just finish it on an optimistic note, if I could convince you to do so, and give me your bull case for high yield, let's say for the rest of this year and into 2024.
Scott Roth: Well, let me give you a few thoughts on loans and bonds. I guess I'll start with bonds. I think what investors need to appreciate is that the quality in the market today is the best it's ever been in the history of high yield, and a lot of the sponsor activity, a lot of the LBO activity has actually been financed away from high yield over the past several years. So fundamental shift in high yield, and I think that just needs to be taken into consideration when you're looking at spreads yields on a historical basis. And our approach to high yield has actually changed a little bit coming out of this zero- interest rate policy, just low interest rate environment in general, where a few years ago we were always trying to identify that discounted name that had some catalysts that would trade up. And so you try to generate a total return in the high single digits. Today, you don't have to go through all those hoops. You have a market that you can build a quality portfolio of BBs, single Bs, with yields of 8.5%, 9%. So you don't really have to stretch on credit quality to get there. You have the BB rating category, which is nearly 7. 5% yield, and I would argue the default rate there is de minimis. So those are sort of the backdrop for high yield and why it makes sense to be involved in this asset class. On the loan side, I would say that is one of the most underappreciated asset classes right now. We've seen an exodus out of that asset class in terms of outflows by its investor base, both retail and institutional. And that's actually just before the asset class realizing what it was built for. And that's the floating rate coupon. And I know why investors elected to sell the asset class 2022, leverage loans outperformed every other asset class by a mile, and if you were investor, you needed liquidity, you sold your winners. Now that ended up being premature. Today we're sitting here, 10 plus percent yield in leverage loans. You run the coupons out to the end of the year and you're talking about north of 12%. So a lot of carry has been built up in this asset class. Other asset classes are going to have a hard time trying to outrun the carry that exists in leveraged loans. And on a risk adjusted basis that is really attractive for an asset class that historically has exhibited low volatility and you're actually secured by the company's assets. So we think the setup for loans is attractive, it's an asset class we've been overweight for the last two years. It's been a bit of an out of consensus trade this year, but we continue to think that's attractive as we think about this higher for longer regime that we're in right now.
Greg Campion: Yeah, yeah. Well, thank you for that comprehensive answer. I appreciate that there's a lot of positive dynamics, I think, that you've obviously just identified both on the bond side and on the loan side. So I think there's a lot to consider, but I think as you've kind of rightly pointed out, you've got some pretty attractive yields as a starting point and there's a lot to like here. So Scott, this has been an awesome overview of what's going on in high yield markets. I appreciate your time today.
Scott Roth: Thanks for having me, Greg.
Greg Campion: Thanks for listening to episode number one of season nine of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast @ B- A- R- I- N- G- S. com. Thanks again for listening, and see you next time.
With yields on bonds and loans near historical highs and the credit quality of the high yield market materially higher than in past cycles, investors may not need to take excessive risks to earn attractive returns in below-investment-grade markets today. Barings' Co-Head of Global High Yield, Scott Roth explains.