Why high yield bonds might withstand a recession

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Why high yield bonds might withstand a recession

Michael Della Vedova, manager of the T. Rowe Price Global High Income bond fund, acknowledged the threat coming from the current environment and hawkish monetary policy from major central banks in response to rising inflation.

But he said the looming recession, if indeed it does occur, would likely inflict less damage on the market than many fear.

Key US financial and housing markets are in much better shape than in previous recessions and banks recently passed stress tests with ease and have solid balance sheets, he said.

Housing debt as a percentage of income also tends to be much lower than in 2007-08 and labour markets are generally in good health.

Mark Benbow, high yield portfolio manager at Aegon Asset Management, agreed there should be fewer defaults in the next downturn than in previous recessions, though admitted numbers would go up.

He said: “Although high yield company fundamentals are in a relatively healthy position, we expect the default rate to modestly increase in 2022 as a result of idiosyncratic factors."

But he added: While defaults are trending upward, it is important to remember that defaults are starting from historically low levels that are not sustainable throughout a cycle.

“As a result, while defaults are starting to increase, we expect the solid fundamental backdrop to help keep defaults below 2 per cent in 2022 and below historical averages throughout 2023."

Similarly, Ahmer Tirmizi, investment manager at 7IM, said the firm's outlook on defaults was that they should remain benign.

"Even if the outcome is not benign, it can still work out ok," he added.

Looking at US equities vs US high yield during the financial crisis, and in particular the 5-year performance from the equity market peak (Oct-2007 to Oct-2012), he said at their worst US equities lost 55 per cent while high yield returns were down 33 per cent.

"However, by the end of the 5-year period, US high yield had recovered so strongly that it was up 57.9 per cent while equities had only returned 0 per cent.

"This is not to say that this will exactly play out again, but to reinforce that even in the worst economic shock we’ve seen since the great depression, HY managed to deliver positive total returns if you just held on."

According to the managers there are broadly three reasons why high yield might be able to withstand a looming recession:

1 It will not be driven by credit

Apart from the pandemic‑induced recession in 2020, most other recent recessions have been credit‑driven, said Della Vedova.

The 2008 global financial crisis and 2001 dotcom bust were caused by the build-up of debt in the US housing sector and internet infrastructure, respectively, whereas this time round inflation is the main cause.

"If the current downturn becomes a recession, inflation will be the main cause. Inflation‑driven recessions are rare – with the last one occurring in 1982-83, said Della Vedova.

"There is a risk of one now because of the colossal amount of fiscal and monetary stimulus pumped into the global economy in recent years – first following the global financial crisis, and later during the pandemic crisis.

"This liquidity has inflated asset prices and driven speculation, resulting in the surging inflation we see today," he added, saying whether a recession is credit‑driven or inflation‑driven was an important distinction to make.

Della Vedova predicted the damage from an inflation-driven recession would be more modest for corporates.

"In the inflation‑driven recession of 1982-83, when the Fed hiked its policy rate to 20 per cent, S&P 500 Index profits fell by 18 per cent.

"In the 1973-74 inflation‑driven recession, when the interest rate reached 13 per cent, profits also fell by 18 per cent. This contrasts sharply with the GFC and dotcom crash, when profits fell by 49 per cent and 25 per cent, respectively."

2 Stronger balance sheets

Many corporates entered 2022 on robust fundamentals, with high cash ratios and low debt, Della Vedova said.

In addition, bond‑issuing firms were able to benefit from attractive funding conditions to push out maturity profiles.

According to Della Vedova, just 1 per cent of the debt of both US and European high yield firms will mature this year, with a relatively small amount of debt maturing in 2023.

The bulk of the "maturity walls of high yield issuers will come in 2025 or later, indicating balance sheets are strong," he said.

Benbow agreed companies' balance sheets were generally strong.

“Many companies have termed out their balance sheets, resulting in few near-term maturity wall concerns," he said. 

"The volume of US high yield maturities in 2022 and 2023 is relatively low, which should allow companies sufficient flexibility to manage their balance sheets and help to minimise default rates in the event of an economic downturn in 2023."

He added: “Fundamental improvement continues to be reflected in rating agency actions as upgrades (rising stars), continue to outpace downgrades (fallen angels).

“Solid fundamentals coupled with rating upgrades have resulted in one of the highest-quality high yield markets in decades. Within the Bloomberg US Corporate High Yield Index, BBs are at all-time highs while CCCs are below historical averages and lower than 2008."

3 There has just been a credit cycle

Covid saw a number of businesses default already. 

In 2020, default rates among US high yield energy firms reached almost 30 per cent, according to Della Vedova, while debt restructurings were popular among European retail firms.

This has helped to separate the wheat from the chaff, meaning it is more likely firms that have weathered one storm will be able to weather the next, according to Della Vedova.

"Those with the potential to survive and thrive beyond a crisis tend to be well supported by sponsor investors. Companies with little prospect of long‑term success are typically allowed to go bust."

Benbow agreed. “Many of the most distressed companies have been cleansed from the high yield market through various downturns experienced since 2008, such as the mini energy crisis in 2015–2016, as well as the global pandemic in 2020," he said.

“This has resulted in a relatively high-quality high yield market with few distressed situations. While the next economic slowdown could result in downgrades, the overall high-quality starting point may help limit distress.”

Della Vedova pointed out that current default rates in US and European high yield stood at ultra low levels of 0.36 per cent and 0.01 per cent.

This was not sustainable in an environment of slowing growth and high inflation, so defaults would inevitably rise, he said.

He added: "Indeed, current market valuations imply a global high yield default rate of 3.9 per cent over the next 12 months. However, we believe the market valuations are being driven partly by general macroeconomic concerns and the actual default rate is likely to come in lower."

carmen.reichman@ft.com