Is the CLO whale back in the water?
Central banks were the focal point of every investor’s attention last week as the Federal Reserve, the Bank of England and the European Central Bank all continued raising rates in their quest to rein in inflation.
It is interesting to note that financial markets have long since priced this tightening in and have in fact begun to loosen financial conditions, pushing in the opposite direction to rates by lowering borrowing costs. The US high yield market has been leading the charge in fixed income with a 4.36% year-to-date return, so it is worth looking again at some of the key credit fundamentals we as portfolio managers monitor within high yield.
Starting with ratings migration, the fourth quarter of 2022 saw three consecutive months in which downgrades outpaced upgrades, with 46 upgrades on $84bn worth of high yield bonds versus 93 downgrades on $102bn of bonds. In January that trend reversed, with 27 upgrades totalling $33.5bn versus 22 downgrades totalling just $19.7bn, which by volume is an upgrade-downgrade ratio greater than 1.7:1. Granted, this is just one month of data, but it does emphasise the strength of the fundamentals within the high yield market and how rating agencies are still looking favourably at companies, particularly as the macroeconomic backdrop is potentially becoming more supportive than we expected only a few months ago.
In addition, in the last couple of months we have started to see a reduction in the volume of US high yield bonds trading at ‘distressed’ levels (at or below a cash price of 70). The distressed universe is considered a precursor to increased default activity, and it is currently at its the lowest level since August 2022, with the volume of distressed bonds decreasing by $28.6bn month-on-month in January (a 31-month high contraction) to $90.8bn, or 6.6% of the US high yield universe. For context, the distressed universe stood at $75bn in February 2020 before spiking to $226bn in March 2020 at the nadir of the COVID-19 crisis, and its 2022 peak came at $124.7bn in September. The average dollar cash price for US high yield bonds now sits at 89.26, three points higher than a month ago. The average price low in 2022 was 83.5, again in September, but it was 100 back in February 2022, so in our view there is still upside to come from the pull-to-par available in shorter dated high yield bonds.
Moving on to default rates, including distressed exchanges the annualised US high yield default rate increased by 18bp to 1.83% in January. This is the highest level since June 2021 and up 151bp year-on-year, but it is still significantly under the long term average of 3.2%, and we are coming from an all-time low default rate of 0.32% set in February last year. While these low default rates are highly supportive in the short term, they are trending towards the historical average with market participants expecting them to persist there for the medium term. There are several factors that should help default rates remain low, such as solid credit fundamentals, a relatively benign distressed universe, limited upcoming maturities, resilient issuer balance sheets, and a historically benign ratings profile for the market (CCC bonds currently make up 10.8% of the US HY universe versus a historical average of 22%). We do think investors should be wary of idiosyncratic default risk and steer clear of the lower rating bands in high yield, but they can take some confidence from the fact that according to JP Morgan research, the 21-year average default rate is just 0.40% for bonds rated BB 12 months before default. If investors can mitigate their default risk, potential returns in high yield remain at attractive levels in our view, and given how high all-in yields are at the moment our outlook for the sector remains positive despite the strength of the 2023 rally.
Finally, looking at issuance, due to a combination of the extraordinary amount of prefinancing that took place in 2020 and 2021 and the extreme volatility witnessed last year, 2022 saw just $106.5bn of new US HY issuance vs $483bn in 2021 (a drop of some 78%). For 2023 syndicates are projecting supply to be around 2x the 2022 level, with estimates broadly ranging from $180bn to $200bn. January saw $19.7bn of new supply, the busiest month since January 2022. While this was met with strong demand and highlighting investors’ appetite to put cash to work in high yield, supply is not likely to be anywhere near the levels reached in 2020 and 2021 as there is just $262bn of bonds maturing through 2024, meaning most issuers can continue to be patient and selective when it comes to managing their capital stacks over the short to medium term. Average annual supply between 2013 and 2021 was $340bn, so the relatively low volume projected for 2023 should lend additional technical support to the asset class over the next 23 months.
When you knit all of the above together, you are left with a supportive credit environment that should bode well in a soft (or soft-ish) landing scenario. While performance has been strong already this year it is clear to us that fundamentals are a lot better than markets were pricing in at the start of Q4 2022, and we think the rally in 2023 so far is justified. The chances of a soft landing have clearly increased, such that we now think this outcome is no less likely than a mild recession for the US economy later this year.
When we look at the US HY index’s yield-to-worst of 8.09%, 188bp higher than its 10-year average, and combine that with what we see in terms of credit fundamentals, these conditions seem ideal for portfolio managers selecting credits.