The $1.4 trillion US junk-bond market is getting junkier, as more debt gets either downgraded or elevated out of the high-yield universe altogether, leaving greater potential risks for investors.
Credit quality is starting to erode as pandemic-fueled “seismic changes” that altered the mix of the high-yield market are now reversing, according to Barclays Plc strategists.
Higher-rated junk bonds, those in the BB tier, are returning to investment-grade as large companies that were downgraded amid the disruptions of Covid-19 improve their balance sheets. But more bonds in this tier are also facing ratings downgrades, too.
As a result, the share of this debt represented in the benchmark Bloomberg US Corporate High-Yield Bond index has declined. At the same time, bonds rated in the B tier, around the middle of the junk spectrum, accounted for a higher proportion of junk supply in 2023, strategists led by Brad Rogoff wrote in a note this month. That tier of debt has become a larger proportion of the index since 2021.
“Index quality is beginning to deteriorate,” the Barclays strategists wrote. “This shouldn’t change the outlook for default amounts in notional terms, but it does make the case that default rates could be higher.”
The deterioration has ramifications for investors who use the index as a baseline for performance and broadly mimic its makeup to help shape their own portfolios, both active and passive. And if the index is getting riskier, most junk-bond funds are getting riskier too — and more vulnerable to potential losses even if the economy avoids recession.
Barclays is forecasting an issuer-weighted default of 4% to 5% in high yield bonds, marking an uptick from the current trailing 12-month issuer-weighted default rate of 3.7%.
Upgrade Effect
There was a net $40 billion of “rising stars” — bonds of companies that won upgrades to investment grade — from 2020 to 2023, according to Barclays, including many credits that made a round trip from blue chip to junk and back to high-grade again. As these companies leave speculative grade, the index inherently becomes lower quality as the stronger companies exit the market.
Ford Motor Co. — among the largest of so-called fallen angels in 2020 — returned to investment grade in November. Occidental Petroleum Corp., meanwhile shed its junk status in May after an upgrade from Fitch Ratings. Packaged-food maker Kraft Heinz Co. climbed to investment-grade last year as well after losing its investment-grade rating in 2020.
While the upgrade cycle has slowed, it isn’t done yet, according to Matt Eagan, co-head of the full discretion team at Loomis Sayles & Co., which had $335 billion of assets under management as of year-end. “There is still some more to go and they are not being replaced at the same pace and just math will just tell you quality is going to go down,” he said in a phone interview.
Downgrade Effect
Credits rated CCC or weaker, the lowest grades, accounted for about 14.4% of the index, compared with 12.2% in December 2021, according to Barclays. The dollar amount of CCC and weaker debt in the index stayed about the same, but the broader index shrank.
Stronger-than-expected economic growth and easing lending standards should keep defaults from spiking in 2024, but the amount of debt maturing in the next couple of years “still poses a challenge for high yield” and may lead to a “mild increase in bond defaults.”
Rising interest rates may also pressure borrowers looking to refinance debt that’s set to come due in the next couple of years, the Barclays strategists wrote in a separate note. They expect the interest rate issuers will have to pay will increase by nearly 2 percentage points, on average.
The so-called maturity wall “has not yet been addressed and still poses a challenge for the high yield market,” they wrote, with higher-cost refinanced debt having the potential to add stress to issuers’ balance sheets and put upward pressure on defaults.
‘Contained’ Risk
To be sure, some money managers aren’t concerned about the changes to the asset class. They still see the index as relatively high-quality on historical basis, and a small uptick in defaults isn’t stopping them from capitalizing on average yields of nearly 8%.
“We think the index is still high-quality today,” said Manuel Hayes, senior portfolio manager at Insight Investment in a phone interview. “Default risk is going to be contained for the most part.”
Alessio de Longis, senior portfolio manager and head of investments at Invesco Solutions, says he is overweight risk assets. And within risk assets, he favors high-yield bonds over investment-grade debt because the economy “remains on solid footing.”
That said, the yield premium offered by high-yield debt over risk-free Treasuries is extremely thin, at just 3.14 percentage points as of Feb. 16. The figure has averaged 4.25 percentage points over the last decade, and can top 6 percentage points in times of stress. Since 2013, spreads have rarely been tighter, suggesting current levels leave little room for relative valuations to improve further.
In high yield, “you have to remind yourself you basically have limited upside potential,” he said in a phone interview, “and potentially very large downside risk.”
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