High-Yield Credit Spread Stability

Considerations for the High Yield Bond Market: The BB-rated High Yield (HY) bond market has shown strong performance, with favorable news recently related to growth and inflation.  Fundamentally, the companies represented in the HY Index have a favorable upgrade-to-downgrade ratio. BB-rated bonds constitute 50% of the HY market, distinguishing them from lower-rated B and CCC companies. BB HY bonds typically feature fixed rate, comparatively lower coupons, resulting in lower liability costs and more manageable debt service. In Contrast, the CCC-rated segment shows a concerning trend, with an upgrade-to-downgrade ratio below 0.5 (2x as many downgrades). The credit quality dispersion, shown in the chart below, reveals that BB vs. CCC-rated bonds trade at a spread margin of ~400 to ~1,200 bps, currently sitting inside of 750 bps.  While CCC credits can generate substantial returns during robust economic growth in a low default rate environment, and have rallied with the market in recent days, CCC deterioration is most pronounced during distress and recession. During the first half of 2020, the BB-CCC spread differential reached 1,200 bps, and in 2016, CCC spreads were even wider. It is noteworthy that Europe is straddling recession, and the BB-CCC European HY bond spreads have recently widened to 1,400 bps, surpassing its peak in 2020. So despite, the recent rally in lower-rated HY bonds, caution is warranted for the weakest segment of corporate credit. The HY bonds historical default rate: BB’s 0.4% default rate, B’s 1.4% default, and CCC’s a stunning 14.3% historical default rate! During a recession, default rates tend to increase significantly from historical measures. Composition of HY Index: 50% BB, 39% B, 11% CCC. 1 year ago, the HY Bond Index had 1.2% default rate. Today, the trailing 12M default for the HY bond market is 2.6%. By Q2 2024, I expect the default rate for high yield bonds exceed 4%. Michael Schlembach, Marathon Asset Management’s PM for High Yield, expects default rates to increase in 2024, with peak default rates potentially reaching ~1.0%, ~3.0%, and >20%+ for BB, B, and CCC’s, respectively. The key will be to invest in the debt of companies with solid fundamentals and financial strength to navigate the pending downturn. If you believe as I do that an economic slowdown (potential recession) is likely in 2024, it might be best to focus on higher quality credits with robust operating businesses within the HY market. Ford serves as a prime example in the BB sector, having recently been upgraded to Investment Grade by S&P, marking it as the largest 'rising star'. Ford represents 2% of the HY index with $41 billion of bonds, its upgrade has spurred demand for other quality BB-rated bonds to replace it. While recent inflows have tightened BB spreads, I advise against trading based solely on the technicals, as this post is intended purely for informational purposes. U.S. HY rated BB vs. CCC Differential:

 🚩A Crucial Market Is Sending Its First Warning Signal The Fed’s rate-hiking campaign could still weigh heavily on the economy, not least by making it harder for companies to access funding. But on the surface, investors seem confident that most US companies will generally be able to handle a slowdown without shutting down. That’s clear in the fact that the high-yield spread — that’s the extra yield that investors demand for buying riskier corporate bonds over safer government bonds — is still quite narrow. This indicates that investors aren’t too concerned about a spike in company failures, which would wipe out the interest from the riskier bond’s payments. But as always, the devil is in the details. Look deeper within the high-yield sector, and you’ll see investors are now asking for much higher rewards for holding the riskiest “junk bonds” – specifically those rated CCC (light blue line in the chart) – compared to the slightly less risky B-rated junk bonds (dark blue). Of course, it’s hardly surprising that CCC bonds boast higher yields than single B’s. They’re marginally riskier, after all. But historically, that difference has been slight. And over the past few months, the gap has been widening significantly. That suggests that investors are increasingly wary of defaults within the most speculative pockets. Now, that could be due to sector-specific concerns – CCC bonds are more common in media, consumer products, and high technology – or concerns that a tougher economic environment could wipe out companies with a weak spot financially. That's a worrying trend. As you can see in the chart, the last time we saw such a gap was right before the dot-com bubble burst. Investors poured money into highly speculative ventures during the tech boom, many of which carried CCC ratings. And as the sustainability of those businesses came into question, investors demanded much higher returns to offset the heightened risks. That led to a sharp spike in the yield spreads of CCC-rated bonds over B-rated bonds, a clear signal that investors saw potential for severe financial distress in those companies. That warning sign started flashing about a year before the bubble burst. A similar pattern unfolding today suggests that not everything is stable beneath the surface. The rise in CCC-rated yields indicates that the chance of defaults for the most speculative companies are rising, and is higher than the high-yield spread suggests. The risk from here is that the economy slows down more aggressively or borrowing costs stay high for longer than hoped, then these fears of defaults could spread to other companies – as it did before the dot-com bubble popped. More worryingly, that could bring trouble for private credit lenders, which loan to similarly smaller, debt-laden private companies. And since private markets may represent an important threat to our financial system, this is a risk worth watching. > Finimize

𝗘𝘂𝗿𝗼𝗽𝗲𝗮𝗻 𝗛𝗬: 𝗰𝗮𝘂𝘁𝗶𝗼𝘂𝘀 𝗮𝗻𝗱 𝘀𝗲𝗹𝗲𝗰𝘁𝗶𝘃𝗲 ⚠️ HY returns look fine on the surface—but the cracks are widening underneath. 𝗪𝗵𝗮𝘁 𝘄𝗲’𝗿𝗲 𝘀𝗲𝗲𝗶𝗻𝗴: • Clear split between higher-quality HY vs. CCCs. 📉 • Restructurings are rising in CCCs, with repeat offenders returning to creditors. • 2020–2022 capital structures set at ultra-low rates now look unsustainable (telecoms a frequent culprit). • Europe’s creditor base (CLOs & funds) complicates turnarounds—few want to own/operate businesses. • That breeds “extend & pretend”: near-term fixes that push firms into a shakier future. 🧭 • In some deals, equity still extracts value when handing over the keys—skewing creditor priority. 🧨 𝗠𝗮𝗿𝗸𝗲𝘁 𝗰𝗼𝗻𝘁𝗲𝘅𝘁: • EUR HY spreads trade near 7-year lows; scarcity and inflows keep valuations rich. • Headline +4.5% YTD masks the divergence; six-month returns are left-skewed in industrials. • No comparable “landmines” in Financials/CoCos; duration keeps grinding lower as issuers sell shorter calls—optionality shifting to them. 𝗛𝗼𝘄 𝘄𝗲’𝗿𝗲 𝘁𝗶𝗹𝘁𝗶𝗻𝗴: • 𝗨𝗻𝗱𝗲𝗿𝘄𝗲𝗶𝗴𝗵𝘁 𝗘𝘂𝗿𝗼𝗽𝗲𝗮𝗻 𝗛𝗬 𝗶𝗻𝗱𝘂𝘀𝘁𝗿𝗶𝗮𝗹𝘀; 𝘄𝗲 𝗱𝗼𝗻’𝘁 𝗯𝗲𝗹𝗶𝗲𝘃𝗲 𝘁𝗵𝗲 𝗰𝗿𝗲𝗱𝗶𝘁 𝗰𝘆𝗰𝗹𝗲 𝗵𝗮𝘀 𝗿𝘂𝗻 𝗶𝘁𝘀 𝗰𝗼𝘂𝗿𝘀𝗲. • 𝗣𝗿𝗲𝗳𝗲𝗿 𝗙𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹𝘀 (𝗔𝗧𝟭/𝗖𝗼𝗖𝗼𝘀): better spread per unit of idiosyncratic risk—so far, risks remain contained. 🏦 • 𝗙𝗼𝗰𝘂𝘀 𝗼𝗻 𝗾𝘂𝗮𝗹𝗶𝘁𝘆, 𝗰𝗮𝘀𝗵𝗳𝗹𝗼𝘄 𝗿𝗲𝘀𝗶𝗹𝗶𝗲𝗻𝗰𝗲, 𝗮𝗻𝗱 𝗲𝘀𝗰𝗮𝗽𝗲 𝗵𝗮𝘁𝗰𝗵𝗲𝘀 (𝗮𝗺𝗲𝗻𝗱-𝗮𝗻𝗱-𝗲𝘅𝘁𝗲𝗻𝗱 𝗿𝗶𝘀𝗸𝘀). 🧩 Bottom line: 𝗿𝗶𝘀𝗸/𝗿𝗲𝘄𝗮𝗿𝗱 𝗶𝘀 𝗹𝗲𝘀𝘀 𝗳𝗮𝘃𝗼𝘂𝗿𝗮𝗯𝗹𝗲 𝗶𝗻 𝗘𝗨𝗥 𝗛𝗬; 𝗸𝗲𝗲𝗽 𝗯𝗲𝘁𝗮 𝗹𝗶𝗴𝗵𝘁, 𝗾𝘂𝗮𝗹𝗶𝘁𝘆 𝗵𝗶𝗴𝗵. 🙏 Guglielmo Zaffaroni for your support. #HighYield #Credit #EuropeanMarkets #FixedIncome #AT1 #CoCos #CLOs #Restructuring #Telecoms #QualityOverBeta #CreditCycle #SpreadDuration #RisingStars #PrivateCredit #IGVsHY #TILTS #Banor #AChartADay

You know it’s tight out there for a bond investor. The Bloomberg High Yield Index Option Adjusted Spread (OAS) over U.S. Treasuries has been at historic lows and decreased further on Friday. It is now 45 bps above the 30-year low for this index (reached in 2007) and is below the daily average for this year (see the chart below). These tighter spreads permeate the entire fixed income asset class and are not confined to one corner or another creating challenges for bond investors globally. Lower spreads are not necessarily a harbinger of bad things. These conditions can persist without any major crisis, especially if the technical and fundamental conditions for them exist and continue. Favorable macroeconomic conditions (per current market expectations), fiscal stimulus (continued tax cuts), lower default environment (thank you liability management), increased demand for bonds and lower bond supplies (as borrowers seek private bilateral credit relationships) all could support narrower spreads. Yet, the risks are to the downside. Tighter credit spreads mean that bonds are more likely to correlate to equities if a crisis or hiccup materializes – spreads could widen as equites go down. Narrower spreads also mean that bond prices cannot increase much from here lowering potential total returns unless spreads tighten more (unlikely). At the same time, investors are not being paid much above US government bonds. The bond portion of the 60-40 portfolio today is thus less effective (more correlation and downside risk) and less attractive (lower income and lower total return potential). What is an allocator to do? They can wait (hope?) for a better entry point, increase duration, invest in lower quality bonds or forgo liquidity. That is, chase yield. Or they may seek to manufacture yield and return through private and structured credit transactions. The increase in demand for private credit by allocators and investors is telling. But as basic private credit in the US and Europe becomes increasingly crowded and PE transactions (a driver of private credit) are taking longer to consummate, private credit writ large might begin to suffer diminishing returns and lower liquidity. Increased competition for a lower number of deals means that private credit funds are competing with each other for the same borrower and thereby compressing pricing and loosening covenants- not usually good for lenders. Complementing basic private credit allocations with credit strategies that are (i) decoupled from the capital markets, (ii) less dependent on financial engineering, and (iii) exhibit resilience even in downturns should help enhance portfolio and provide insurance against a credit downturn. We have health insurance, house insurance and car insurance. We might as well add portfolio insurance. PS: Not AI content. Not Investment advice.

August 2024 - US Corporate Bond Recap US INVESTMENT GRADE CORPORATE BONDS: In August, US Investment Grade (IG) corporate bond spreads remained stable at 93 basis points (bp), unchanged from the end of July. However, this stability belies significant volatility earlier in the month when spreads widened to 110bp due to yen carry unwind trades disrupting the market. This spike brought spreads closer to their 5-year average of 119bp, albeit briefly. The 5-year low for US IG corporate spreads is 80bp. As of August 30, 2024, the yield on US IG bonds stood at 4.94%, with a duration of 7.1 years. US HIGH YIELD CORPORATE BONDS: US High Yield (HY) corporate bond spreads tightened to 305bp by the end of August, down from 314bp at the start of the month. Notably, spreads had widened to an impressive 381bp on August 5th, presenting a significant alpha opportunity for those with the conviction to invest in US HY corporate bonds at that time. The 5-year average spread for US HY corporates is 402bp, with a 5-year low of 262bp. The yield on US HY bonds was 7.30% as of August 30, 2024, with a duration of 2.9 years. OVERALL PERFORMANCE: August proved to be a favorable month for both US Investment Grade and High Yield Corporate Bonds, with returns of +1.57% and +1.63%, respectively. These returns were largely driven by movements in interest rates. During the month, the 2-year US Treasury yield fell significantly by 34bp, from 4.26% to 3.92%, while the 10-year US Treasury yield declined by 13bp, from 4.03% to 3.90%. This flattening of the yield curve brought the UST 2s10s curve close to positive territory for the first time since July 2022, indicating that inflation appears to be under control and recession fears are diminishing. Front-end rates are decreasing as the Federal Reserve is expected to cut rates. The CME Fed Watch Tool, which uses futures pricing to gauge market expectations for interest rate changes, indicates a 30% chance of a 50bp rate cut and a 70% chance of a 25bp rate cut at the upcoming FOMC meeting on September 18th. YEAR-TO-DATE PERFORMANCE: Fixed income returns continue to lag behind the rallying equity markets. Year-to-date, US Investment Grade Corporate Bonds have returned +3.49%, and US High Yield Corporate Bonds have returned +6.29%. According to LSTA Morningstar, US Leveraged Loans have returned +5.84%. Cash, represented by 1-3 month US T-Bills, has returned +3.64% YTD. In contrast, equities have significantly outperformed fixed income and cash, with the S&P 500 up +18.4% and the NASDAQ up +18.0% YTD.

US High Yield corporate bond spreads over Treasuries always increase before a recession starts. Such was the case in 2000, 2007, and even early 2020. Here's where they stand now: High yields spreads are currently 3.21 percentage points. They are up marginally from their YTD lows of 3.03, but still below their year end 2023 levels of 3.39 points. Since the end of the 2020 Pandemic Crisis, HY spreads have been as high as 5.9 points (July 2022) and as low as 3.0 points (December 2021). We are much closer to the low end of the band than the highs. HY spreads today are essentially the same as the lows from 2015 - 2019 (3.2 points), when confidence in the US economy was generally strong. Why this matters: High yield investors are a cautious lot because the best they can do is receive timely payment of interest and principal. If they are pricing HY bonds aggressively, it is because they expect continued economic growth. Bottom line: US large cap stocks are not alone in their belief that the US economy will avoid recession over the next 1-2 years.

Shallow duration and recent spread widening are incrementally constructive for high yield moving into year-end, though total risk compensation remains limited. Option-adjusted spread at 301 bps for the Bloomberg US Corporate High Yield Bond Index as of Nov. 21 is muted by historical norms, though a handful of basis points wide to the one-year and five-year averages. With duration for the asset class anchored below three years from early May, excess-return breakevens (spread over duration) of 96 bps are roughly 20 bps up from the cycle low in late-2024. Yield per unit of duration (total return breakevens) is helping to support the narrow spread. At 217 bps, it's roughly 34 bps above the two-decade average. Research and data at BI STRTN<GO> on the Bloomberg terminal.

Been pitched private credit recently? That often coincides with periods when credit spreads are already tight. When spreads are compressed, investors may be assuming additional credit risk without receiving much incremental yield in return. The tradeoff becomes less favorable as compensation for risk declines. Historically, periods of unusually tight credit spreads have often been followed by spread expansion and higher market volatility. During those transitions, risk assets have tended to reprice quickly. In similar environments, investors have often emphasized higher credit quality rather than reaching for yield in lower-quality segments of the market. Know what you own and the associated risks. #privatecredit #highyield #creditspreads