Safety first: Why quality matters in high yield

July 25, 2024

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The high-yield market held up well in the first half of the year, but as Jamie Cane and Kevin Ziets explain, prudence and careful credit selection will remain vital in the coming months.

Despite concerns over interest rates staying higher-for-longer, softer economic data in recent months, growing pressure on consumers and episodes of politically driven volatility, the US and European high-yield (HY) markets have shown resilience so far this year.

While mostly driven by refinancings and maturity extensions, primary issuance in the first half saw a significant increase over the same period last year. US high yield issuance hit US$131 billion in H1, up 62% year-on-year, while the European market reported US$76 billion of issuance, a 120% year-on-year increase.¹

This supply was well absorbed by investors, with the weighted-average yield for new deals in the first half falling from 8.7% to 8%. In the secondary market, weighted-average yields of 7.6% in the US and 6.1% in Europe have been stable.¹ 

Defaults have also been contained and are expected to decline in the coming months. According to S&P Global, the European speculative-grade default rate is expected to fall from 4.3% at the end of May to 3.75% by March 2025; the US equivalent is expected to peak at 4.75% in December before falling to 4.5% by next March.²

Furthermore, of the 78 defaults that took place in the first half globally, nearly all were in the lowest quality part of the market, as Figure 1 shows. 

To understand what investors might expect next, we put the questions to Muzinich & Co. portfolio managers Jamie Cane (JC) and Kevin Ziets (KZ).

Earlier this year, HY benefited from a supportive technical backdrop and the pull-to-par effect. Has much changed?

JC: Broadly, those themes remain in place. We saw a short-lived but modest spike in yields around the French election – less than 50 basis points (bps) - but that quickly reversed.

Overall, spreads are tight, particularly optically, but the pull-to-par effect persists. The cash price of the European market remains around 95, and we're seeing companies refinancing their 2025 and 2026 maturities on a regular basis. We are still benefiting from this pull-to-par effect; it is becoming less evident as cash prices rise and fewer bonds are available, but it continues to provide a good source of additional return — real, not just theoretical.

The technical outlook continues to be robust. Net issuance has been negligible; there have not been many new issuers entering the market or existing issuers funding M&A transactions. Most activity is for refinancing. We have also seen more rising stars than fallen angels, affirming the positive technical backdrop. New issuance continues to be well-received.

“The pull-to-par effect continues to provide a good source of additional return — real, not just theoretical.”

Jamie Cane

KZ: The situation in the US market also remains stable. We are still about 30 basis points off 10-year tights (Figure 3) — those levels are justified by the strong technical factors Jamie mentioned.

Despite the strong level of issuance in the first half, over 80% was for refinancing, indicating minimal net supply. Flows may have slowed slightly, but the technical picture remains robust. There are signs of consumer fatigue, notably in sectors like airlines and mid-tier restaurants, while some retailers catering to lower- and middle-tier customers reported disappointing earnings. This suggests continued strains on lower-end consumers. Additionally, there has been weakness in the housing market, especially entry-level housing.

How is that pressure on consumers impacting credit markets?

KZ: There has not been much of a direct impact. Some names in sectors like building materials might underperform due to recent trading weakness. However, homebuilders maintain strong balance sheets and have been relatively unaffected from a credit perspective. Airlines may see softness but can react with capacity reductions quickly and remain in good shape overall. The broader market reflects strong credit metrics, underpinning its stability. Unless there is a major macro event or widespread economic weakness, I do not foresee significant changes.

JC: There has not been any real sign of consumer-led weakness among European HY issuers. On the face of it, this might seem surprising because European growth has lagged the US and consumers have faced significant inflationary pressures. But consumers have proved resilient, helped by wage inflation and continued growth.

Has there been any impact from the ECB’s decision to cut rates in June?

JC: The impact has been muted; the ECB's rate cuts were well signposted, and, because of that, rates have been relatively stable. There was a little nervousness around the prospect of "higher for longer" rates in April, but weaker US macro data since then has shifted the outlook.

The short duration of the broader HY market (around 3 years) means a 100bps move in spreads impacts cash prices by around three points — less than half a year's carry.

KZ: The lack of a move by the Fed has contributed to weakness in certain sectors, like homebuilders and commercial real estate. However, recent soft data has pushed rates lower. The market appears to be running ahead of the Fed; over the course of the year, the Fed reduced expectations from 3 cuts to 1, while the market adjusted from 7 cuts to none, then back to 2.

High yield's short duration may prove beneficial in the face of softer economic conditions, particularly if the curve steepens rather than shifts materially lower. As we reach an inflection point in Fed policy, we may marginally lengthen duration in our portfolios. But, as always, individual credit selection remains key to our positioning rather than making a large call on duration.

“High yield's short duration may prove beneficial in the face of softer economic conditions, particularly if the curve steepens rather than shifts materially lower.”

Kevin Ziets

Political risks are prominent in the headlines, from France's snap election to the UK’s change of government, and the upcoming US election. How should HY investors view these events?

JC: Political events are typically a source of volatility rather than systemic pressure or defaults. For instance, Brexit's impact was short-lived, and the HY market quickly returned to tight spread levels. The recent French election similarly saw spread fluctuations but quickly normalised. Italy's far-right government turned out to be more pragmatic than feared, mitigating market concerns. Political risks tend to be transient. It is also worth mentioning that investors in Europe, based on recent experience, have a perception that the ECB will intervene in more extreme circumstances. 

KZ: US markets appear to have a priced in a higher probability of a Republican victory. But the reaction in HY spreads has been muted because the broader focus on economic growth and lowering inflation is likely to be the same regardless of who occupies the White House. Moreover, the ability to implement policies may be impacted by thin majorities in Congress, financial market considerations, and global geopolitical developments.

That is not to say the outcome will not have implications for different sectors. A Trump win would increase expectations of deregulation and tax cuts but could potentially add to inflationary pressures if higher tariffs or stronger immigration policies were implemented. We will evaluate energy producers, healthcare providers, heavy importers and renewable energy names amongst others that could be affected by any potential change in policy. A win by the Democrats would likely see a continuation of current policies with an emphasis on infrastructure spending, trade security, student debt and other consumer relief programmes.

From a sector or ratings perspective, has there been any change in where you see opportunities and risks?

JC: There have not been any sectoral shifts. In HY, there will always be idiosyncratic issues affecting individual credits, and we have seen stresses at certain companies. That is a function of the higher interest rate regime over the past 2 years, where some companies with excessive leverage struggled to refinance at affordable levels. But those are typically CCC or low single-B rated firms, and we work with our analysts to filter out those with meaningful refinance risk. Our focus remains on higher quality BB and single-B credits, where we can leverage bottom-up fundamental analysis to identify companies offering a yield premium while maintaining strong credit quality at a portfolio level.

KZ: In the US, 3 sectors — telecoms, broadcasting and cable — have shown weakness this year. This is due to structural challenges: declining demand in the case of traditional broadcasting and cable TV businesses; capital-intensive network upgrades to fibre broadband for telecoms. We have managed risk by moving away from areas in structural decline or more cyclical sectors, and allocating towards less cyclical names in areas like technology where we can find stable businesses with strong fundamentals.

“Our focus remains on higher quality BB and single-B credits, where we can leverage bottom-up fundamental analysis to identify companies offering a yield premium while maintaining strong credit quality at a portfolio level.”

Jamie Cane

 

References

1.Ion Analytics, ‘LevFin Highlights, 1H24,’ as of July 9, 2024
2.S&P Global, ‘Default, transition and recovery,’ as of May 22, 2024

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of July 2024 and may change without notice.

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Index descriptions

HP4N – The ICE BofA ML BB-B European Currency Non-Financial High Yield Constrained Index contains all non-financial securities in The ICE BofA ML European Currency High Yield Index rated BB1 through B3, based on an average of Moody's, S&P and Fitch, but caps issuer exposure at 3%.

JUC4 - The ICE BofA ML BB B US Cash Pay High Yield Constrained Index contains all securities in the ICE BofA ML US Cash Pay High Yield Index (J0A0) rated BB1 through B3, based on an average of Moody's, S&P and Fitch, but caps issuer exposure at 2%.

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