Solid fundamentals and higher yields signal potential opportunities in the year ahead.
As we transition into 2023, investors’ efforts are likely to shift from a focus on monetary policy announcements to better understanding the impact of the U.S. Federal Reserve’s (Fed) fastest hiking campaign on corporate fundamentals. The good news here is that U.S. high yield issuers, overall, face the economic slowdown to come with balance sheets that have fully retraced the impact of the pandemic.
Impressively, leverage is sitting near its lowest level in the post-financial crisis period, while interest coverage is at its best levels, nearly 25% higher than on the eve of the GFC (global financial crisis). Less than 25% of the high yield bond market maturing through 2025 suggests minimal liquidity needs, particularly through the next 24 months. However, as with any other growth slowdown, we do see the corporate default rate rising from today’s depressed levels but peaking short of the magnitude typically experienced in recessions. Overall ratings composition, with over half of the asset class rated BB and just 11% CCC-rated, helps drive this view. We also note that as the largest industry in high yield, the energy sector, has undergone a significantly positive transformation, both operationally and financially, since 2015. This should help moderate default concerns in this cyclical cohort, relative to other growth slowdowns. Finally, while every cycle is different, forward returns when the yield-to-worst exceeds 8% (ending 2022 at 9.01%) historically have been quite favorable for investors (see Figure 1). In the history of the ICE BofA High Yield Index since 1996, there have never been two-consecutive years of negative returns.