In our early December quarterly strategy group meeting, we debated the outlook for the high-yield market in 2022 and what it means for portfolios. At present, we favor maintaining a slightly defensive risk positioning given tighter valuations. While the macroeconomic backdrop and corporate fundamentals generally remain positive, we see some points of concern emerging at the margin. We expect high-yield credit spreads to move sideways in a year that could see plenty of volatility given multiple tail risks. However, we believe the ability to dynamically adjust positioning in the event of a significant repricing of credit risk will be key in 2022.
Macro: positive, but less positive
We continue to observe “yellow flags” on inflation and are watching for signs that inflationary pressures could shift from transient to permanent, leading to faster-than-expected tightening. On the flipside, previous Federal Reserve (Fed) policy cycles suggest that the high-yield market tends to perform well during the early stages of hiking when rate increases are primarily in response to a strong economy. If the need to address inflation is the primary driver of central bank action, then the outcome appears to be less clear-cut. For instance, the momentum of emerging economies has stalled recently as their central banks have started raising interest rates to address inflation.
Corporate fundamentals: neutral
High-yield issuers have generally adopted relatively credit-friendly financial policies since the start of the COVID crisis in early 2020. Leverage ratios have fallen as companies have recovered and focused on balance sheet improvement. Average leverage for new issues has stayed flat, albeit at the elevated levels of the last few years, while quality — as measured by the market’s relatively low CCC component (11.5%) — remains high. We detect somewhat more aggressive financial policy behavior, as evidenced by a modest increase in the use of issuance proceeds for dividends. We are also witnessing heightened leveraged buyout activity (LBOs), although the deals to date are mostly well capitalized, with significant equity cushions. Looking ahead into 2022, we have some concerns about the potential for margin pressure to negatively impact corporate credit metrics.
Spreads are still in the tightest decile of history. While the market has moved away from its all-time lows, it remains highly compressed with a large degree of negative convexity — meaning there may be limited price appreciation potential from incremental spread tightening. That said, we see pockets of attractive valuations in emerging high-yield markets, such as Chinese high yield, where market volatility has driven credit spreads well into distressed territory.
Dealer inventories remain high going into year end, and dealers have limited appetite to take on more inventory. Investor sentiment indicators have come down to a more neutral level, but equity raising activity is still high, with equity valuations in some areas of the market verging on bubble territory. While this does not directly affect the broader high-yield market, it could eventually spill over in some form, via stock buybacks or LBOs at elevated valuations. Collaterized loan obligation (CLO) volume has been strong, but not at alarming levels, while CLO defaults — which are a more reliable signal of trouble — remain low.
Tail risks: neutral
For 2022, we see several potential tail risks. These include:
- The COVID Omicron variant or any subsequent variants of concern;
- More persistent inflation resulting in faster-than-expected tapering or interest-rate hiking by the Fed and other central banks; and
- Geopolitical risks, in particular, increased China-Taiwan frictions given the global supply-chain implications.
However, we acknowledge that these risks are not unique to the high-yield market, and to the extent that they are known, are likely to be priced in already.
In summary, we expect 2022 to be a year of sideways moves but with potentially lots of volatility along the way. We therefore believe being able to dynamically adjust risk positioning as needed in the event of significant price volatility will be critical going forward.