SBH Investment Summit:
High Yield Fixed Income

[Jim Dadura] Hello and welcome to the 2022 Segall Bryant & Hamill Investment Summit. My name is Jim Dadura. I’m the Director of Fixed Income and I am fortunate enough to have Greg Shea, he’s a Portfolio Manager with our high yield strategy here with us today to talk about the high yield market, the opportunities, and risks that he may be seeing. So, we’ll jump right into it. And Greg, it’s been a tough year for bonds. We’ve seen the broad market down double digits. High yield is down about 11% through last night’s close. Is there a compelling reason for people to be investing in high yield in this environment?

[Greg Shea] Thank you Jim and thank you everybody for joining us. Yes, we do think there’s a compelling reason. This adjustment process, while it has been painful this year, the flip side of this is high yield is trading at a very attractive yield today about 8.76%. We don’t get to see these types of yields outside of stress periods. Think COVID of 2020 on this chart, the oil price collapsed in 2015 and 2016. Fears of the Euro breakup in 2011 and then, of course, in the Global Financial Crisis. And what do higher yields really mean? Well, that there is greater cushion to absorb future interest rate increases or spread widening. And a quick example here, Jim, the high yield market with its duration of 4.5 years and yield to worst of almost 8.75%, rates would need to rise just over 190 basis points to wipe out one year of income. So, we think that’s pretty compelling today and provides a lot of cushion.

[Dadura] Well, those yields definitely look attractive, but I have to play devil’s advocate a little bit. We have a Federal Reserve that’s been hiking interest rates; rates have been going higher all year. The Federal Reserve plans to continue hiking interest rates. Many investment analysts out there are predicting a recession next year or at least an economic slowdown. Are there risks we need to be concerned about in the high yield space?

[Shea] That’s a great question, Jim, and one we get all the time, is the risk of credit loss in the high yield market. This is the number one risk and why we watch and have expectations about the future default rate going forward. Let’s check out where defaults are today. And defaults are near all-time lows. Why is that? We’re not seeing any stress yet in the high yield market. It’s because corporations have fixed their balance sheets. They’ve got good corporate fundamentals, they’ve used this period of low interest rates to push out their debt maturity. So, they’re not facing a maturity wall, many of them. However, we do agree that defaults are going up. They can’t go any lower than where they are today. They’re headed up, and what gives us confidence in them going up is, let’s flip to the next slide. We overlaid the default data series with a new data series, let me explain this one a little bit. Every quarter the Fed goes out and they do a survey of about a hundred banks in the United States and they ask questions about credit availability. And these senior loan officers return this survey, and they report whether they’re tightening credit standards, making it harder for corporations to get loans, whether they’ve left the standards the same quarter-over-quarter, or whether they’re loosening standards and opening the spigot for more and more corporations to get lending. And what we’ve graphed here is the percent of senior loan officers, so the total amount of them that are indicating that they’re tightening credit, or making it harder to get loans. And we found that this is a nice leading indicator of defaults. You can see that in this data series the gap has really widened this year with the federal senior loan officers all indicating that they’re restricting credit. And so, in this type of environment with this backdrop that you’ve spoken about and slowing economy, we believe it’s very important to focus on quality and know the companies that you’re owning when getting loans is tougher in this period.

[Dadura] Okay, thank you, Greg. We all know the Federal Reserve has kept interest rates low for a long period of time. As you mentioned, companies have extended their maturities, they’ve also added a lot of debt over the years and you’re saying that there’s a good chance that defaults could rise, Is credit quality a concern? Has credit quality been decreasing with all this debt that’s been issued?

[Shea] Well, this is a great question and not all credit markets are created equal. We are seeing divergent trends. So, what we’ve done on this slide is we’ve laid out the three major public credit markets, there is over 7 trillion dollars in debt. And we’ve really dug in here and looked at where is all the junk going? Who’s becoming junkier and, to your point, levering up and pushing their balance sheets? And we look here, and we see that the investment grade and leveraged loan market, the two markets on your left have increased their exposure to the junkier parts of the market. We’re showing the percentage of the ratings composition to the highest rating category within each market. And with those trending down, it tells us that those markets are taking more of the junk, while the traditional junk market has actually gotten less junky or more high quality. The percentage composition to the BB sector is near its highs during the last 15 years. So, we think it’s better positioned than it has been in the past. And we think that’s another feather in the cap for the high yield market, Jim.

[Dadura] Okay, so if I want to summarize what I’ve heard today, yields are high, it’s an attractive entry point from a yield perspective. Credit quality in high yield is higher, has been actually increasing, while other sectors, such as leveraged loans and investment grade credit qualities have been going down. Sounds pretty attractive to me. Is there anything else you want to add? Is there anything that I’m missing? Should people just invest in high yield straight away?

[Shea] Well, let’s be clear, Jim, we’re not suggesting that people buy everything in high yield with this backdrop. As I mentioned, we’re focused on high quality in this market and what we did here is we broke that yield out within the three ratings categories in high yield. We’ve got CCCs, Bs, and BBs. Now CCCs, you look where that yields at sitting at today. It has been higher in the past, multiple times. And when you look at Moody’s has a dataset that goes back a hundred years. The 10-year cumulative default rate on the CCC sector is just over 45%. That’s almost a coin flip that a CCC goes bankrupt in a 10-year period. And so, with that backdrop of tightening credit, loans are harder to get, pushing out their debt maturities, we’re avoiding that sector. A sector that we see as very attractive today is that higher quality part of the market, the BB sector. It’s got a third of the default risk when you look over that 10-year time period than the CCC market and you’re able to lock in just over a 7% yield today in that market. And when you look historically where that’s been over time and that’s represented, we haven’t seen it at these types of levels outside of the Global Financial Crisis. So we’re paying a lot of attention there and that’s why we see the quality part of the high yield market as compelling, Jim.

[Dadura] Well, thank you, Greg. I think the information you provided today is great. As always, we focus on high quality at Segall Bryant & Hamill. High yield has attractive yields right now, the duration is relatively low relative to the yield, providing some cushion, and sounds like as long as you focus on high quality, it’s a nice entry point into this market. Thank you for your time today, Greg, and thank you all. If you’d like any additional information, please reach out to our sales team.