From here to maturity

Read this article to understand:

• Why European high-yield bonds can offer better value than US equivalents
• The importance of credit selection  
• The role of covenants in protecting bondholders

Sticky inflation, elevated interest rates and vulnerabilities in the US banking sector have all affected investor sentiment towards risk assets at various points in 2023.

Nevertheless, the high-yield market has held up well. Issuers remain relatively resilient, as evidenced by solid balance sheets and favourable credit metrics. In August 2023, rating agency Moody’s revised down its peak default rate projection for 2024 from 5.1 per cent to 4.7 per cent, citing tighter-than-expected credit spreads this year.¹ And yet yields remain attractive compared with recent history (see Figure 1), presenting a compelling case for allocation to the asset class.

There are reasons for investors to remain cautious, however. The macroeconomic picture is still uncertain, with the impact of high inflation and the rapid tightening cycle yet to fully play out. In the US, labour disputes and congressional wrangling over the federal budget may yet spook markets.

In this Q&A, the co-heads of global high yield at Aviva Investors, Sunita Kara (SK) and Brent Finck (BF), highlight careful credit selection and regional allocation, along with close attention to covenant quality, as essential considerations for high-yield investors in the current environment.

How do you assess events in the high-yield market this year?

BF: On a trailing 12-month basis, global high-yield bonds have generated double-digit returns. And yet average yields remain elevated at around 8.5 per cent. In historical terms, this represents an attractive entry point.

The average price of outstanding high-yield bonds globally is still less than 90 cents on the dollar. So, there is the potential for capital appreciation if interest rates recede. This is why we expect high yield to remain attractive, even if spreads stay the same or widen. The asset class is not dependent on tighter spreads to generate positive total returns.

SK: The market has been resilient despite headwinds, and we expect this to continue throughout the year. There has been some deterioration in credit metrics, but issuers’ leverage and interest-coverage ratios remain solid. Even in the current scenario, corporate balance sheets are stronger than historical averages (Figure 2). This provides a cushion for some degree of deterioration in the coming months. Meanwhile, some macroeconomic indicators, particularly in the US, show signs of improving, which should support the market.  

Where do you see the best opportunities and, conversely, what are the riskiest areas?

SK: Our strongest conviction lies in the regional allocation. We focus on developed markets, in the US and Europe. We see a relative value advantage in investing in European high yield. It is a high-quality market and there is potential to pick up 50 basis points over US high yield on a spread basis. In addition, hedging the euro exposure back into US dollars provides a hedging gain.

BF: In the US, an attractive carry can still be earned within defensive sectors. For example we see the potential for sectors such as healthcare to benefit if an economic slowdown leads to lower labour costs. Investors don’t necessarily need to invest in the most cyclical parts of the market; good total returns are achievable in less economically sensitive areas.

The overall size of the US high-yield market has shrunk by $200 billion in the past two years. What are the implications for investors?

BF: The reduction in the market size has had a significant positive technical impact. Investors continue to receive coupons and, as bonds are retired, they have capital to reinvest. Coupled with lower new issuance, that trend has supported the market.

Nevertheless, we anticipate an increase in new issuance going forward given the substantial amount of debt maturing over the next three years – companies are likely to proactively refinance in the coming months.

SK: We see a similar story in the European market. The market is now 11 per cent smaller compared to a year ago but we don’t expect it to increase in size. More refinancing activity is expected over the next two years, with companies focusing on rolling over maturing liabilities rather than raising new capital.

CCC-rated bonds have generated strong returns in 2023. Why is this the case, and what is the likelihood this will continue?

SK: If we rewind to January, the spread on CCC-rated bonds was over 1,000 basis points – what we would describe as distressed levels. This offered compensation for the risk of a more meaningful pick-up in defaults. However, while defaults have occurred this year, they have come through at a measured pace and not reached the magnitude initially expected. Along with the relatively benign macroeconomic backdrop, that is the key reason why CCC-rated bonds have experienced a 160-basis point rally in the year to date. 

BF: From a positioning standpoint, most investors came into the year with underweight exposure to CCC names. As the macro environment proved more resilient than expected, investors gradually repositioned, adding CCC names, which contributed to a strong rally in that part of the market.

The concern going forward will be many of these companies still face challenges accessing capital at affordable rates. There is a division within the CCC market between better-performing names and a more-distressed portion where yields are still in the double digits. The latter group may struggle to refinance debt. For investors, this makes credit selection within CCC names extremely important.

Have you increased exposure in this area, considering your high-quality bias?

BF: We have added CCC exposure throughout the year, although we remain underweight and cautious. We have reassessed the economic downturn scenario: our House View anticipates a softer landing for the global economy than previously feared.² Therefore, we are more comfortable with taking some selective risk. However, we are mindful of the looming 2025 maturity wall. Most of these companies need to address the issue at least 12 months in advance, which is likely to lead to a surge of refinancing activity in 2024.

One interesting aspect within this is private equity firms that fund some high-yield issuers are doing “self-help” to support these businesses, such as through equity injections or other means to improve the overall economics of the refinancing deal. From our perspective, whether the issuer is public- or private-equity owned, it is important that robust covenant packages are in place to safeguard bondholder rights.

On covenants, you mentioned a strengthening of covenants the last time we spoke.³ Is this trend continuing in both Europe and the US?

BF: To some extent. US investors have managed to influence tighter covenant terms, although we are still seeing a delayed impact from a time when covenants were weaker. Going back three-to-five years ago, covenants were weak and many companies lacked an early trigger for default, which meant a significant portion of a company’s value could be eroded before an actual default happened. This situation led to recovery rates falling well below the long-term average.

SK: In Europe, we have not witnessed enough new issuance to determine any changes in covenant quality. Most issuance has been of high quality. Some companies might transition to investment-grade status within 12 to 24 months, and this is often accompanied by covenant-free investment-grade documentation. But as we progress into next year, when more issuance is expected from lower-quality names, we will be in a better position to assess where covenants should lie based on investor demand.

Earlier this year, your expectation was for a moderate uptick in defaults. Is this still the case?

SK: We continue to expect global high-yield defaults to remain within the 4-4.5 per cent range over the next 12 months. Defaults may be more pronounced in the US, given it is a lower-quality market with a higher number of CCC-rated names.

There are ways to mitigate some kinds of defaults. For instance, some issuers offer incentives to bondholders to extend maturities – a trend known as “amend and extend” – or issue new bonds at a deep discount as a way to avoid the full increase in the interest costs associated with CCC-priced bonds today.

BF: We do not foresee the conditions for a significant spike in defaults, as seen in past economic cycles. However, we expect this elevated default level to persist for a while longer.

From a duration standpoint, it will take time for the impact of higher interest rates to fully materialise. The average coupon on US high-yield bonds remains around six per cent today, while the market yields 8.5 per cent. Over time, interest expense will rise, and companies will need to adjust, but this will be a gradual process rather than an abrupt one.

How have persistent inflation and higher interest rates affected the market?

BF: Higher interest rates will increase the interest burden on companies, affecting their ability to service debt. This is evident in interest-coverage ratios. However, only about ten per cent of the market has repriced in the last 12 months.

The market largely maintains a fixed-rate coupon structure, so the impact of higher rates has been relatively muted and credit quality remains relatively strong. From an inflation standpoint, there are concerns around its impact on profit margins. Still, many companies have managed to maintain margins, largely because they possess sufficient pricing power to pass on the inflation impact to customers.

SK: Higher rates have obvious implications given the approaching maturity wall. A year ago, many BB-rated issuers believed that interest rates had peaked and they therefore postponed refinancing their bonds. However, the situation has evolved. Now, it’s not only issuers of CCC-rated short-dated bonds facing challenges; higher-quality issuers realise they will have to pay double the coupon of their existing debt. The window is shortening for issuers of various rating levels to come to market.

When issuers come to market, are they seeking short-term debt on the expectation rates will come down, or do they still aim to extend their maturity profile?

SK: It depends on investor demand. Given how flat the risk-free yield curve is, from an investment perspective it is more efficient to own near-term front-end bonds. This applies to the primary and secondary market, where there is attractive all-in yield in the front end, coupled with positive convexity due to bonds trading at a discount. This is what issuers must contend with. Investors are not necessarily incentivised to go further out on the maturity spectrum.

Issuers generally prefer to lock in a reasonable tenor for their bond maturities. But their final decision often hinges on their expectations of what the overall interest rate environment will be in two to three years’ time. This is because high-yield bonds often have a callable feature, allowing them to be redeemed after two or three years even if the final maturity date is much further out.

Are there other factors on the horizon high-yield investors should monitor over the coming months?

SK: We are closely monitoring the macroeconomic landscape for signs of a slowdown, especially the effect of rate hikes, which may be more pronounced in Europe. Europe is also more likely than the US to suffer from potential spillover effects from the weakness in Chinese growth.

Another theme to watch is the resurgence of inflation. The recent increase in the oil price impacts headline inflation numbers. If this has a knock-on effect on wage inflation, central banks may have to take further action. We have seen the impact rate hikes can have on sentiment towards risk assets, so it’s possible that some of the returns generated year-to-date could be reversed in that scenario. We should also keep a close eye on market access, as this will ultimately influence default rates.

BF: In the US, there are potential sources of disruption. The US government’s student loan repayment moratorium expired on September 1; as a result, interest has begun accruing on student loans again, with the first payments due in October. This could potentially impact discretionary spending among US consumers. Furthermore, the United Auto Workers union is engaged in intense negotiations with the “Big Three” auto manufacturers, resulting in labour strikes which have the potential to expand and be increasingly disruptive.

Lastly, despite the agreement of a stopgap spending bill, there is the potential for a US government shutdown in November if a longer-term budget agreement is not reached. While these factors may not be sufficient to derail the overall macroeconomic picture, they could generate headlines in the coming months.