We’re in a more positive cycle for high yield bonds, as quality has structurally improved and average duration has come down. Meanwhile, private credit has grown, the syndicated loan market has grown, while the global high yield market has matured, says Justin Jewell.
Key points
- The combination of high all-in-yields and falling duration creates a powerful forward total return profile.
- Underlying credit fundamentals are robust.
- While the growth of private credit has been substantial, we are seeing asset flows and issuers come back to public markets.
In today’s world, high yield investors can realistically expect yields of 8-9%. Not that long ago, yields were half that. Of course, there are challenges at the tail of the market. There always are. We are paying attention to default rates, because back in 2021 and 2022, defaults were near zero. The challenge that slightly detracts from returns over the next couple of years is that defaults are expected to be back in the 2.5-3.5% range. After the historic level of rising rates, businesses are operating in a world with higher costs of capital, and some could struggle through this period. The long-term average for defaults has been about 3%, so we’re essentially going back to a more typical environment, where companies occasionally fail.
Some investors may question whether they are being properly compensated for the additional risk inherent in high yield credit because spreads are relatively tight, but the market has shifted in several significant ways.
First, companies having been holding off refinancing past debt that was borrowed at very low rates. This has had the effect of shortening the duration of the high yield market. Therefore, the shorter duration nature of the bonds makes them less risky.
Secondly, we’ve also seen an upward shift in quality. The CCC component of the market hasn’t grown, as many riskier companies have looked for alternative sources of financing. Meanwhile, the BBs have continued to grow, creating greater depth to the investment universe.
In fact, a central story for credit markets since 2016 is that the high yield channel has not been the riskiest part of the fixed income market. We’ve seen significant growth in private credit markets over the past eight years. Certainly, there are companies which may have problems and therefore choose to re-finance privately and away from the glare of public markets. In the previous low-rate environment, investors became quite interested in private credit, but more recently, that trend has been reversing.
More flows have been returning to public markets. And companies are seeking to come back towards public markets because basically, the cost of private credit is high and unless you have to pay it, you don’t necessarily want to. Of course, we’ve seen some companies try to come to the public markets and fail, they’ve tended to be narrower businesses with more leverage – low quality borrowers. The larger trend has been public markets refinancing private credit transactions.
As we shift through our investment universe, we find companies that have challenges. As active managers, that’s how we differentiate ourselves. We don’t think buying that whole world, an index fund or ETF, is going to be a winning strategy. This is our core skillset, credit picking, rolling our sleeves up, understanding documentation, understanding covenants, identifying businesses with good paths to asset sales and to deleveraging. We believe active managers can add value by identifying the issuers that can survive higher debt-servicing costs and find solutions for their refinancing requirements.