High Credit Yield Outlook: Considering Catalysts for Wider Spreads
- High yield spreads have stayed remarkably tight despite rising recession risks. How long do you think spreads can hold in?
High yield spreads generally reflect the premium investors demand for accepting the risk of capital loss due to defaults. We see a number of factors that have contributed to the persistently low level of high yield spreads.
- Easy monetary policy. In the wake of the pandemic, easy Federal Reserve policy drove interest rates lower. Many high yield credits extended maturity walls out and reduced interest expense. This helped pave the road for defaults to reach cycle lows.
- Average Dollar Price/Quality. Looking at the past 20 years, the average dollar price of the Bloomberg High Yield Index is now the lowest it’s been at a time when spreads have been at current low levels. We believe this contributes to an attractive “margin of safety” in the high yield market, which is helping to keep a ceiling on spreads. Furthermore, the lowest-quality (rated B+ and lower) cohort within the Bloomberg High Yield Index remains at the lowest levels since 2007.
- Issuance. A lack of net new issuance in 2022 shrunk the size of the high yield bond market.
Looking ahead, we see catalysts that could move spreads wider. If corporate profitability begins to meaningfully deteriorate in the coming quarters, we expect market participants to demand higher spreads to compensate for the perceived increase in default risk. Furthermore, if the current regime of higher interest rates continues, many over-levered capital structures that were built during an ultra-low-yielding environment will likely struggle to refinance their bloated balance sheets and profitably operate at higher costs of interest expense. Weakness in these structures could affect sentiment across the high yield market.
2. Markets seem to be anticipating a relatively shallow downturn. What kind of default rate are you expecting in 2023?