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High Yield’s High-Quality Overhaul

While most segments of fixed income offer paltry yields with growing risk levels—either credit or interest rate—and valuations that are back to pre-pandemic levels, the high yield market remains one of the few areas that still provides positive real yields while benefiting from a credit quality mix that is at all-time highs.  As a percentage of the total US high yield market, the portion of BB-rated issuers (the highest-rated cohort of the non-investment grade universe) is now at record highs, while on the opposite end of the quality spectrum, only 13% of the index is rated CCC or worse—close to all-time lows. Putting this together, after adjusting for improved credit quality, today’s high yield market is priced at even more compelling valuations than headline numbers suggest.

Exhibit 1:  High Yield Bond Ratings Distribution (LH) and Market Size (RH, $ billions)

Source: ICE BofA. Data as of 31 December 2020. Credit ratings and market value based on the ICE BofA US High Yield Index. For illustrative purposes only.

The recovery in creditworthiness can be attributed to a variety of factors, both technical and fundamental. Part of the evolution is simply related to the weakest companies’ restructuring or leaving the index. Pandemic-related disruption resulted in relatively heavy default activity in areas of persistent distress over the last several years—notably in energy and retail. But the bigger impact on market composition has come from the migration of fallen angels. A wave of downgrades in 2020 resulted in a record number of formerly investment grade companies’ entering the high yield index, bringing with it about $250 billion of bonds from the likes of established and well-known companies like Ford, Kraft Heinz and Occidental Petroleum. What’s been investment grade’s loss has been high yield’s gain, however. Not only do these companies tend to have larger, more liquid capital structures, but in many cases, they have enough levers to pull to return to investment grade status in the near future.

Exhibit 2:  New Issuance Volume
High Yield Bonds and Leveraged Loans

Source: ICE BofA/S&P LCD. As of 31 May 2021. Issuance volumes based on ICE BofA US High Yield Index and S&P Leveraged Loan Index.

From a fundamental perspective, the high yield market has benefited from lower levels of riskier issuance in favor of widespread refinancing activity relative to recent years. A less robust M&A environment has kept a lid on some of the riskiest financings used for leveraged buyout and debt-funded dividend recaps relative to past regimes. Additionally, broad access to capital has provided the most leveraged borrowers plenty of options to address their liquidity needs. Record new issuance in 2020 and YTD has allowed borrowers to shore up their balance sheets, lock in record low borrowing costs and push upcoming maturities well into the future. As a result, the percentage of issuance directed toward refinancings instead of leveraged LBO-related transactions is at all-time lows.

Exhibit 3:  Indicators of Aggressive Issuance—LBOs/Dividends as Percent of Market Size

 

 

 

 

 

 

 

 

Source: ICE BofA/S&P LCD. Data as of 31 May 2021. Based on new issuance with proceeds used for leverage buyouts or dividend recapitalizations across high yield and leveraged loans. Value represent rolling 3-month and 12-month averages as a percent of total bond and loan market value.

The improving market composition comes at a time when the macroeconomic environment is broadly supportive for high yield borrowers, too. Businesses are showing clear signs of recovery and in many cases are posting sales and profit growth in line or better than 2019 results. With widespread access to capital and few signs of distress in the market, we would expect defaults to continue their fall from 2020 highs and move well below long-term averages. Ultimately, high yield valuations may be back to pre-COVID levels, but investors who fail to look deeper may miss the meaningfully improved market composition.