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High Yield Credit—First Half 2021 Review and Thoughts for What’s Ahead

Through the first six months of 2021, high yield credit markets have provided an above-coupon return on the back of tighter credit spreads—though this has been somewhat offset by the increase in Treasury yields. The benign credit backdrop and deep bid for yield has favored a down-in-quality approach, particularly among economic reopening beneficiaries. Across the capital structure, loans have benefited from investor focus on rising rates. Loans have provided strong absolute gains so far, but receding inflation expectations led to lower Treasury yields in Q2, which in turn weighed on relative returns for the floating-rate asset class.

Exhibit 1: Leveraged Credit Scorecard—2021 Returns

ICE BofA US High Yield Index

JPMorgan Leveraged Loan Index

Source: ICE BofA/JPMorgan. Performance as of 30 Jun 2021. Past performance does not guarantee and is not a reliable indicator of future results. ICE BofA US High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. JPMorgan Leveraged Loan Index is designed to mirror the investable universe of the US dollar denominated leveraged loan market.

 

Low Default Environment Supports Valuations

While spreads remained tight, they’ve largely reflected a positive high yield environment devoid of default risk or distress. The first six months of 2021 have been the quietest for default activity since 2011. The par-weighted default rate has declined to 2.5%, from 7.0% at the start of the year as large COVID-related volumes fell out of the 12-month calculation. Widespread access to capital has provided corporate borrowers with plenty of options to address liquidity needs, meaning distress has largely disappeared from the market. As it stands, only 14 CUSIPs in the ICE BofA US High Yield Index are trading below $70, indicating investors’ limited expectation for future defaults.

Exhibit 2: High Yield Default Rates

Source: ICE BofA. As of 30 Jun 2021. Trailing-12 month par-weighted default rate. Based on constituents in the ICE BofA US High Yield Index.

Exhibit 3: High Yield Distress

Source: ICE BofA. As of 30 Jun 2021. Distress based on face value of ICE BofA US High Yield Index constituents with spreads in excess of 1,000bps. CUSIPs based on ICE BofA US High Yield constituents.

 

Issuance Trends in the Recovery Phase

Issuance trends remained firmly in favor of corporate borrowers, with a record pace of gross issuance. More than $600 billion of bonds and loans were issued in 2021 as borrowers moved to take advantage of record low borrowing costs. Much of the proceeds have been used to refinance—often paying expensive call premiums to do so—meaning the net supply of total debt over the last six months is not materially larger than levels at the start of the year.

Exhibit 4: New Issuance by Month

Exhibit 5: Cumulative New Issuance

Source: ICE BofA. As of 30 Jun 2021. Based on gross issuance for the ICE BofA US High Yield Index.

 

Fundamentals Accelerating with Global Recovery

The pace of credit repair is accelerating alongside the global economy. After peaking in Q1, leverage levels are beginning to decline with revenue and operating earnings trending above pre-pandemic levels. Leverage remains elevated relative to history, but record low borrowing costs help offset some of that burden. Not surprisingly, we expect the improvement in credit metrics to accelerate throughout the rest of the year and beyond as the global economic recovery gathers steam.

Exhibit 6: Gross Leverage vs. Interest Coverage Ratio

Source: ICE BofA. As of 30 Jun 2021. Gross leverage calculated as total debt divided by earnings before interest, tax, depreciation and amortization (EBITDA). Interest coverage ratio is calculated as EBITDA divided by interest expense. Earnings and interest expense are on a trailing 12-month basis.

Exhibit 7: Leverage by Industry

Source: JPMorgan. As of 30 Jun 2021. Transportation and Gaming/Leisure have negative EBITDA over the last 12 months which has led to large negative leverage figures and as such they are excluded from this chart.

 

Valuations Reflect Positive Economic Momentum

Spreads have compressed in all corners of the market, tightening through pre-COVID levels to make new post-crisis tights. The continued bid for yield and lower default expectations have provided momentum to the convergence of valuations between higher- and lower-rated risk. As it stands, the high yield market is exhibiting the lowest level of pricing dispersion since 2007, characterized by the proportion of bonds trading within 100bps from the index level.

Exhibit 8: Credit Spreads by Credit Quality           

Source: ICE BofA. As of 30 June 2021. Credit spread to worst is the difference in yield between a U.S. Treasury bond and the lowest possible yield that can be received on debt security with an early retirement provisions of the same maturity.  Past performance is not a reliable indicator of future results.

Exhibit 9: High Yield Dispersion
Proportion of Face Value +/-100bps of Overall Index Level

Source: ICE BofAML. As of 30 Jun 2021. Past performance is not a reliable indicator of future results.

 

Investment Implications

It’s important to remember credit valuations should be measured relative to forward-looking default expectations. With the dual tailwinds of below-average default activity and elevated refinancings, current early-cycle dynamics suggests the path for spreads is probably lower still. Even so, with the decline in dispersion and valuations at post-crisis lows, further excess returns are likely to come from credit-specific alpha and not from broad market beta. While we don’t think the market is adequately compensating broad, directional credit risk, we do feel the market is offering plenty of unique idiosyncratic and relative-value opportunities for fundamental credit pickers.