SBH Investment Summit
Fourth Quarter 2023:
High Yield

The Advantage of Quality High Yield in Today’s Market

The high yield (HY) market has outperformed other fixed income sectors so far this year, generating positive returns despite rising interest rates. However, several factors—including an uptick in default rates, a higher cost of capital, and the possibility for volatility going forward—suggest to us that the higher quality BB segment is the optimal area within high yield, providing yield and more defensive portfolio positioning.

Troy Johnson, CFA, Director of Fixed Income Research, and Greg Shea, CFA, Senior Portfolio Manager, provide an in-depth analysis of the high yield market, discussing how different rating categories have fared and the ability of quality high yield to withstand volatility going forward.

 

Key Takeaways

  • Lower quality CCCs have led performance this year, outperforming the quality part of the market. However, defaults are rising while spreads are declining, suggesting potential volatility for riskier segments of the market going forward.
  • High-yield market leverage is healthy overall with net leverage at 3.6x and interest coverage at 4.8x. However, lower-rated CCC companies remain highly leveraged with low coverage, leaving them vulnerable to rising rates and refinancing challenges.
  • BBs, the higher quality part of high yield, have offered the best risk/reward over long-term horizons. Our analysis shows BBs consistently outperform broader high yield, assuming a $1 million investment and 5% withdrawal rate.

[Kyle Airola] With all the volatility we have seen so far this year in interest rates, how are the high yield markets holding up and what have you seen year-to-date?

[Troy Johnson] High yield has performed very well relative to other areas of the fixed income market year-to-date, with a positive return of about 4.5% despite rates moving higher. For instance, the 5 year Treasury, which is similar in duration to the overall high yield market, has moved from a 4% yield at the beginning of 2023 to approximately 4.8% at the end of October 2023, up about 80 basis points (bps).

High yield’s performance illustrates the power of income and the yield “cushion” that the high yield market possesses. The market entered the year yielding just shy of 9% and had a duration of less than 4 years. The high yield that was available in the market cushioned the underlying movement in bond prices from rising rates, resulting in outperformance and positive year-to-date returns.

That was not the same for the (Bloomberg) U.S. Aggregate Bond Index (Agg). It carries a lower yield and higher duration which has resulted in negative performance year-to-date. Most importantly, the cushion remains available for high yield investors today. The high yield market’s yield-to-worse is slightly higher than where it started the year, at about 9.4% today, while carrying a similar duration to the Agg. Even the highest quality component of the market, the BB segment, offers yields in excess of 8% today.

[Airola] Digging deeper on that last point, how have the different rating categories performed in a year when stocks are up over 7% and economic forecasters, who were predicting a recession at the beginning of the year, have been wrong?

[Johnson] That is interesting. Despite the wall of worry, Exhibit 1 shows that CCCs have led the high yield market higher all year long. The year-to-date return of CCCs is approximately 9%, and it has really outperformed the quality part of the market, the BB rating category, which has returned less than 3% so far through late October.

Exhibit 1: CCCs Have Led the High Yield Market All Year (Total Return (%) 2023)


Data as of 10/30/23. Source: Bloomberg U.S. High Yield 2% Issuer Capped and Bloomberg U.S. BB Indexes.

 

[Airola] Troy, with all the uncertainty over the direction of the rates and the overall economy, it seems a little unusual that high yield would be outperforming within the fixed income markets, and particularly CCCs. Do you think that is likely to continue?

[Johnson] Time will tell on both fronts, but it is certainly worth questioning the outperformance of CCCs during this period of uncertainty, volatility in rates, and rising default activity. Exhibit 2 shows that defaults have been increasing off 2022 lows, while spreads on corporate bonds, or the risk premium you receive to compensate for potential defaults, have been declining. This divergence between the two data sets suggests that we could see surprises in the near future, as we expect the default rate to continue to climb.

Exhibit 2: Corporate Spreads and Default Rates Are Telling Different Stories

Data as of 9/30/23. Source Bloomberg, BofA Global Research.

 

[Airola] Greg, I will turn it over to you. Do you think the high yield market is set up to handle more volatility?

[Gregory Shea] Let’s break down the fundamentals and how the market is positioned today, looking at both balance sheet leverage and interest coverage.

Exhibit 3 shows that net leverage levels at 3.6x and interest coverage at 4.8x compare favorably to long-term averages over the last 12 years. The high yield companies have been able to lock in low rates during the low-rate regime, and this does not seem alarming. However, digging deeper, there are haves and have-nots. Looking specifically at the different rating cohorts, we see that the CCC rated companies at the index level remain highly levered and have low interest coverage levels today. We believe that these companies may not be well positioned for higher rates and refinancing this debt.

The high yield market’s cost of capital has more than doubled compared to where yields were before the Fed started raising rates. So, what kind of interest coverage would a company need to refinance at these higher interest costs today? Assuming a company’s cash flow and debt levels remain the same to where they are today, which could be conservative given economic uncertainty, a company’s interest coverage ratio would need to be more than 2x to stay above 1x after refinancing all the debt at today’s higher interest rates. CCCs, with 1.3x interest coverage, could see pressure, whereas the quality part of the market, at 7.0x interest coverage, is well positioned.

Exhibit 3: High Yield Net Leverage and Interest Coverage

Data as of 9/30/23. Source Bloomberg, BofA Global Research.

 

[Airola] Let’s pull this all together. The high yield market continues to have an attractive yield cushion relative to its duration, but not all areas of the high yield market are prepared for volatility moving forward.

[Shea] That is correct, and we continue to think the quality part of the market offers the best risk/return over multiple different investment horizons. Exhibit 4 shows the quality part of the market, which we are designating as the BB sector, relative to the overall high yield market, which has a mix of BBs, Bs, and CCCs. We analyzed three different time horizons: 5, 10, and 30 years. Note that each of these periods has times when the market has done well for high yield and when the market has sold off. This analysis assumes a $1 million initial investment, as well as an annualized 5% monthly withdrawal rate. The result: quality wins in all three-time horizons.

Exhibit 4: Growth of a $1 Million Investment

Data as of 9/28/23. Source: The Bloomberg Barclays Indices – High Yield 2%, BB Indices.

 

Additional Resources:

Taxable Fixed Income

Fixed Income Insights

 

The opinions expressed in this video are solely the opinions of Segall Bryant & Hamill or an unaffiliated third party. You should not treat any opinion in this video as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinions. The opinions expressed in this video are based upon information considered reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this video does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this video. For illustrative purposes only.

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