Despite spread widening, defaults in the high yield market have yet to hit significant levels. Will structural changes in the market limit the damage from defaults in future crises?
Read this article to understand:
- How the high-yield bond market has evolved over the last decade
- Why these structural changes could help reduce default risk in a period of spread widening
- Why a deeper and longer recession than expected remains a key risk
Default rate peaks in high yield prior to 2020 were typically at ten per cent and above. By contrast, in 2020, despite a large contraction in the global economy caused by the COVID-19 pandemic, the default rate peaked around six per cent.
Of course, companies benefitted from enormous government stimulus that helped them stay afloat. However, the risk of capital loss from defaults may also be impacted by structural changes that could reduce it in the longer term.
Today, inflation and policy tightening by central banks are again creating negative momentum and we expect a moderate and gradual increase in defaults. But this is not yet significant, despite credit spreads widening since the start of 2022 (see Figure 1).
Figure 1: Moody’s speculative grade default rate
Source: Moody’s, Barclays as of June 30, 2022
We also expect the cycle to be shorter and shallower than previous crises for four key structural reasons: an improvement in issuer quality; higher liquidity; the extensive refinancing that preceded the current environment; and access to alternative sources of funding.
The ratings mix and balance sheets are both stronger in this cycle, as we discuss below. Secured bonds also make up more than a quarter of the index, while the average high-yield coupon is at historic lows, translating into a lower cash price index. Therefore, even if default patterns follow historical recession averages, the overall probability of default and loss-given-default is likely to be lower than in previous crises (see Figure 2).1
Figure 2: Default expectations remain low
Note: The default forecast is hypothetical, does not represent actual data and is not a guarantee of future results.
Source: Moody’s, Barclays as of June 30, 2022
Higher quality issuers
Firstly, the risk profile of the universe has changed: the high-yield market has seen a structural composition change towards better-quality issuers. The share of BBs is about ten per cent higher today than it was in March 2011, prior to the European sovereign debt crisis, while the proportion of CCCs is a few hundred basis points lower today than on the eve of the global financial crisis in 2008.
The high-yield market has seen a structural composition change towards better-quality issuers
This is largely due to the large number of fallen angels from the 2020 COVID crisis, not all of which made it back to investment-grade ratings before surging inflation and the war in Ukraine effectively stalled the upgrade/downgrade cycle.
Fallen angels comprise a large part of the BB universe and remain high-quality issuers. Their approach to leverage and capital allocation is more conservative than that of typical high-yield companies, reflecting an investment-grade mentality. However, to protect portfolios to the downside in this context, fundamental analysis will be key to identify high-quality issuers.
Figure 3: Bond quality rating has increased since the global financial crisis
Note: Benchmark shown is the Bloomberg Global High Yield hedged to US$.
Source: Barclays Live, as of August 22, 2022
From a geographic perspective, there are more CCCs in the US high-yield market2, for which funding will become more expensive if the Federal Reserve continues raising interest rates.
Meanwhile, energy companies are significant because they make up around 15 per cent of the US high-yield market. Their balance sheets are in much better shape now than going into previous crises because they have benefited from elevated oil prices recently. Even withstanding a 20 per cent drop in the oil price, we still expect them on balance to be cashflow-generative. They are also continuing to pay down their debt, shrinking representation in the high-yield market and thereby mitigating the risk they could present through a prolonged downturn.3
We expect defaults in US and European high yield to rise to similar levels over the next 12 months
On the other side of the Atlantic, European high yield faces macro factors like gas rationing coming into play, which could cause additional stress on companies on top of the European Central Bank hiking rates.
While there are slight nuances between the two regions, we expect defaults in both to rise to similar levels over the next 12 months, towards four per cent, and in line with long-term averages. Moody's forecasts the default rate to rise to 2.8 per cent by the end of 2022 and 3.8 per cent by July 2023.
More liquidity
The second major structural change, which again follows the COVID crisis, is that many companies (but not all) have increased liquidity. This includes lower-quality issuers and cyclical industries like the cruise line and auto sectors, which have historically been more exposed to defaults, being more dependent on consumer discretionary spending. Today, cruise lines generally have over one year of liquidity, even as they ramp up their operations.4
Following the COVID crisis, many companies have increased liquidity
Having raised large liquidity buffers in 2020, and in the face of continued uncertainty, they have maintained conservative balance sheets and a high level of liquidity, meaning they should be better able to withstand an economic downturn than in previous crises.
Interest coverage has increased significantly over the past 12 months, while leverage, after peaking in 2021, has returned to levels in line with the decade before COVID (see Figures 4 and 5).
Figure 4: Interest coverage has improved
Source: Bank of America Global Research, as of May 3, 2022
Figure 5: Lower leverage ratios
Source: Bank of America Global Research, as of May 3, 2022
Refinanced debt
Even before the pandemic, high-yield issuers were focused on refinancing to extend the maturities of their debt, capitalising on the prolonged era of low interest rates and borrowing costs. Most recent proceeds were used to refinance existing debt rather than pay for acquisitions and/or leveraged buyouts, as was the case in 2007 in the run up to the global financial crisis (Figure 6).
Figure 6: Refinancing activity (per cent)
Source: JPMorgan High Yield Leveraged Loan Research, as of June 1, 2022
As a result, around 20 per cent of the market will mature by the end of 2025, while the majority will see maturities coming between 2026 and 2029. This means issuers will enjoy low coupons for a few years yet.
It also allows room for companies to experience a downturn without needing to access the bond markets, which have not only become more expensive but at times even remain shut to new issues, until risk premia are priced appropriately for the asset class.
Access to alternative funding sources
Finally, while the global high-yield bond market has matured, so have other avenues for companies to raise capital, such as private credit. Even during the first six months of 2022, when issuance in the bond market was down, companies were able to access a private credit investor base to sell debt.
During the first six months of 2022, companies were able to access a private credit investor base to sell debt
For example, Morrisons, which was expected to come to the high-yield bond market earlier in the year, placed its debt privately among a few investors instead.5 Although such access comes at a premium, it at least means sufficient funding can sometimes be raised outside the high-yield market when needed.
The high-yield investor base has also diversified, as shown by the recent increase in collateralised debt obligations (CLOs), particularly European CLOs, which have a bucket that allows them to invest into high-yield bonds as well as loans.6 With leveraged-loan defaults forecast to rise to 4.5 per cent by July 2023,7 the high-yield market is a welcome diversifier.
A prolonged recession remains a key risk
A greater proportion of higher-rated issuers; lower leverage and large liquidity buffers; longer maturities; and more diversified investors and funding sources: these structural changes help explain why high-yield default rates remain low despite widening spreads and rising interest rates.
The key risk is if the current downturn turns into a deep and long recession
The key risk is if the current downturn turns into a deep and long recession. While companies have ample liquidity to see them through a difficult period, there will come a time when they need to access public markets, whether equity or debt. The closer we get to the 2026-2029 peak in maturity profiles, the more difficult it will become for companies to refinance if the economic environment remains challenging. But, for now, that refinancing wall is a worry for another day.
