Is High Yield still attractive? An update

Is High Yield still attractive?An update as of August-23Is High Yield still attractive?An update as of August-23

Is High Yield still attractive?An update as of August-23

Introduction: An Argument for High Yield Markets Amid Economic Slowdown In June 2023, we published a viewpoint describing the high yield asset class as the sweet spot amongst a range of fixed income asset classes. While July and August confirmed most of this thesis regarding economic resilience, and spreads tightened accordingly, some new development regarding the refinancing conditions are worth another look. Back in June our bullish thesis for high yield credit was based on an optimistic assessment of the effective refinancing risk for high quality high yield. Lower spreads have confirmed that analysis. But, over the summer, the refinancing conditions changed materially along two dimensions.

A window of opportunity for B credits The Q2 earnings seasons indeed confirmed the earnings resilience and even if leverage increased slightly on average, the overall level remains close to historical lows. One key reason for this innocuous leverage variation is that slightly lower Ebitda is mitigated by financial policies favoring debt reduction. Refinancing conditions materially deteriorated 18 months ago, which means capital structures need to be reassessed and most of the time deleveraged. As detailed in TOBAM’s FI June piece of research, the high yield universe will be split into two halves: these issuers that generate enough cash flow to stabilize their debt load and those that won’t be able to come to market or source funding to refinance upcoming debt.

Back in June, the primary market was active but biased towards secured debt and high-quality issuance. One of the reasons why few B credits were bringing new bonds to market was that the yields the market was demanding to fund lower quality creditswere too high. Summer brought a real improvement in relative valuation of B vs BB credits in this regard. Refinancing costs as defined by the yields for 5+ years bonds compared to historical coupon paid on bonds maturing in less than 2years time, are now in line for both Investment Grade, BB and B credits (Figure 1).

Figure 1: Global HY and IG refinancing costs (%) by rating category

More amenable valuations for lower quality, in addition to a dearth of new issuance, will certainly drive some new primary activity in September. As default risk in the current macro-economic context is essentially determined by refinancing risk, this situation bodes well for the High Yield market as a whole.

Why Europe's Refinancing Woes Outweigh America's

The reason why this refinancing game will define market fate for the quarters to come is that short-term debt is too large aproblem to be ignored: 8.7% in the US and 18.7% in Europe for the next 2 years which jumps to 22.7% and 43.6% respectively over the next 3 years. As high yield debt is usually to be refinanced roughly12 months in advance, late 2024, early 2025 will be the pivotal moment for high yield defaults and the stakes are much higher for the European market (Figure 2).

Figure 2: USD and EUR High Yield share of bonds with less than 2 years to maturity (in %)

Unfortunately, a taller maturity wall is not the only European specificity – despite a strong outperformance from the short-term credits in Europe over the last two months, the refinancing costs in Europe and the US started to diverge. In our view, the next 6 months will be a defining moment for European HY default rates. The primary market activity needs to pick up significantly for the market to absorb a massive issuance. If this doesn’t happen, we might see European default rates increasing above 4% - levels unseen since the GFC. As Europe ventures into uncharted refinancing territory, the imperative for geographic diversification in high-yield portfolios has never been more pronounced. The higher maturity wall and diverging refinancing costs are two symptoms of higher risk. These haven’t come with lower returns. More precisely, higher risk-free rates have compensated for lower spreads for USD high yield credit that currently offer the same yield to investors than earlier in June. Even euro income focused investors have therefore few reasons to focus solely on Europe.

Figure 3: Global HY and IG refinancing costs (%)

IV. CONCLUSION

Solid High Yield fundamentals have been confirmed by the Q2.23 earnings season It is still attractive to lock income in High quality HYBut lower spreads create a new opportunity for lower quality issuers to refinance short term debt Refinancing is a much starker challenge for Europe than the US as EU is suffering from a higher maturity wall and diverging refinancing costs The need for geographic diversification has never been more pronounced Solid High Yield fundamentals have been confirmed by the Q2.23 earnings season It is still attractive to lock income in High quality HYBut lower spreads create a new opportunity for lower quality issuers to refinance short term debt Refinancing is a much starker challenge for Europe than the US as EU is suffering from a higher maturity wall and diverging refinancing costs The need for geographic diversification has never been more pronounced

Solid High Yield fundamentals have been confirmed by the Q2.23 earnings season

It is still attractive to lock income in High quality HY

But lower spreads create a new opportunity for lower quality issuers to refinance short term debt Refinancing is a much starker challenge for Europe than the US as EU is suffering from a higher maturity wall and diverging refinancing costs

The need for geographic diversification has never been more pronounced

Solid High Yield fundamentals have been confirmed by the Q2.23 earnings season

It is still attractive to lock income in High quality HY

But lower spreads create a new opportunity for lower quality issuers to refinance short term debt Refinancing is a much starker challenge for Europe than the US as EU is suffering from a higher maturity wall and diverging refinancing costs

The need for geographic diversification has never been more pronounced

I DO NOT UNDERSTAND BULLET POINT 3. ABOUT TOBAMTOBAM is an asset management company offering innovative investment capabilities whose aim is to maximize diversification. TOBAM’s Maximum Diversification® approach, supported by original, patented research and a mathematical definition of diversification, provides clients with diversified core exposure, in both the equity and fixed income markets. The company manages approx. $6billion (Dec 2022) via its Maximum Diversification® strategies Its team includes 47investment professionals. CONTACTSParis 49-53, Avenue des Champs-Elys ées75008 Paris France Dublin New York Client Serviceclientservice@tobam.fr ABOUT TOBAMTOBAM is an asset management company offering innovative investment capabilities whose aim is to maximize diversification. TOBAM’s Maximum Diversification® approach, supported by original, patented research and a mathematical definition of diversification, provides clients with diversified core exposure, in both the equity and fixed income markets. The company manages approx. $6billion (Dec 2022) via its Maximum Diversification® strategies Its team includes 47investment professionals. CONTACTSParis 49-53, Avenue des Champs-Elys ées75008 Paris France Dublin New York Client Serviceclientservice@tobam.fr