Near term, our view on the high-yield market remains that a neutral-to-slightly cautious risk posture, with a heavy focus on security selection, is warranted amid spiking COVID numbers, the US political transition, the waning effects of government stimulus, and credit spreads having tightened from earlier this year. Longer term, however, our outlook is more positive as we see plenty of reasons to be optimistic as we look out nine to 12 months from now.
Macro: Strong medium-to-longer term
- We anticipate a difficult short term marked by increased credit stress over the next couple of months, along with a possible reacceleration in high-yield defaults, followed by a much more supportive medium-to-longer term.
- We expect the global economic backdrop to rebound strongly in 2021 and into 2022, particularly as COVID vaccines become reality and if governments deliver additional stimulus.
- European economies could begin to show improvement as early as the first quarter of 2021, while the US economy is likely to strengthen in earnest starting in the second half of the year.
- One big question for high-yield investors right now is: Will the market engage with the near-term downside risks or look through to next year’s expected favorable upside?
Corporate fundamentals: Challenged, but improving
- After a meaningful uptick in high-yield defaults from April through July 2020, the default rate has fallen materially on the back of massive monetary and fiscal stimulus, along with wide-open capital markets (Figure 1).
- We could see the default rate pick back up modestly as we move through the winter, but it is our expectation that defaults will continue to trend lower as 2021 unfolds.
- The quality of high-yield issuance has remained strong (e.g., more than 80% B rated or higher), while many issuing companies are in balance-sheet “repair mode.”
- As of this writing, most segments of the global high-yield market are around their median valuation levels relative to historical spread ranges.
- Much of the “COVID discount” from earlier this year has been recouped, but pockets of opportunity remain. In sectors directly impacted by COVID, security selection is key.
- We expect some business models to fail due to permanent secular and/or behavioral changes, while others can adjust to survive if capital markets give them adequate time and liquidity.
- Dispersion of potential returns remains high, particularly in CCC rated bonds and more troubled high-yield sectors such as energy.
- To the extent that one is bullish on global spread tightening, investors may be able to reap the most value from emerging markets high yield at this juncture.
- 2020 has been one of the briskest years in more than a decade for new high-yield bond issuance. However, this supply flood has been met with very strong demand.
- We believe demand is likely to stay strong for the foreseeable future, as global interest rates stay low and aging demographic cohorts continue to seek higher yields.
- Bid/ask spreads have come down quite a bit recently but remain above their pre-COVID levels, making trading still relatively expensive.
- Some indicators show the market to be currently overbought, with some of the “safer” segments (e.g., BB rated bonds) having become very crowded.
Tail risks: Lower
- In general, the tail risks now facing the high-yield market have diminished significantly in the wake of the US election outcome.
- The market is still somewhat apprehensive about a second COVID wave over the winter, although we see such concerns as being largely offset by the positive tail risk of further vaccine announcements.
- While inflation risk accompanies generous monetary and fiscal stimulus, we believe this risk may already be reflected in market positioning.