Tom Ross, corporate credit portfolio manager, believes that after a prolonged period of spread tightening, returns in 2022 among high yield bonds will be driven more by understanding the mechanics of individual companies’ fundamentals.
- Negative real yields (yields after deducting inflation) are likely to continue to drive investors towards higher yielding parts of fixed income.
- Tight credit spreads, however, leave less margin for error and are likely to lead to more volatile markets and greater return dispersion.
- Countering the inflation risk is expectations of continued strength in the economic recovery, with rigorous credit analysis helping to identify those companies with strong fundamentals.
It has been quite a journey from the very bleak days of early 2020 to the close of 2021. During that time, credit spreads (the additional yield of a corporate bond over an equivalent government bond) have declined from decade-high wides. Throughout, the monetary policy backdrop has been supportive, with low interest rates and asset purchase programmes helping to anchor financing costs at low levels. Meanwhile credit conditions have been broadly favourable as the economy has picked up and companies have sought to reduce high leverage (debt levels) as cash flows improve. 2022 will be notable for the policy tailwind dissipating, with individual credit performance mattering more to overall returns.
The fork in the road
Central banks have already signalled their shift to tighter monetary policy, although the trajectory may be affected by COVID variants if any of these prove to be concerning. We anticipate market volatility in the first half of 2022 fuelled by concerns about inflation. We think inflation could subside later in 2022 provided that supply chains reconnect and the disinflationary demographic and technical forces reassert themselves; this should help limit the extent of any interest rate rises. High yield bonds have historically performed better than investment grade bonds in an inflationary environment and we would expect this to remain the case but we are cognisant that starting yields and credit spreads are relatively low. A key area of focus for us is differentiating between those companies that are able to pass on higher costs and those that could suffer margin erosion.
We are paying particular attention to the crossover space – the credit ratings area that surrounds the border between investment grade and high yield. Often a source of pricing inefficiencies we believe this area is ripe for more companies to make the transition from high yield up to investment grade status, including several of the cohort of issuers that were downgraded during the peak of the COVID crisis in 2020. The difference between the spread on a BB rated high yield bond and a BBB rated investment grade bond remains high, offering the potential for spread tightening as certain issuers are progressively upgraded. In fact, the spread ratio (dividing BB spreads by BBB spreads) is near a decade high, indicative of stronger relative value within BB bonds.
Figure 2: Spread ratio BB/BBB
Source: Bloomberg, ICE BofA BBB US Corporate Index, ICE BofA BB US High Yield Index, ICE BofA BBB Euro Corporate Index, ICE BofA BB Euro High Yield Index, Govt OAS, 25 November 2011 to 26 November 2021.
While we believe we are still mid-cycle, credit spreads are closer to late-cycle tight levels, even accounting for the widening that took place in late 2021. There is some creep of bad behaviour among issuers, with debt again being used to fuel takeover activity. Meanwhile, covenant quality (the terms attached to debt such as a step up in coupon paid on a bond if a company breaches certain financial metrics) has deteriorated. This often happens when bond issuers and investors are more confident but we need to be careful that yields and terms reflect a reasonable balance against risks, hence why rigorous credit analysis will be even more important in 2022.
We anticipate companies seeking to refinance while yields remain relatively low, particularly to replace more expensive debt issued at the height of the pandemic emergency. The very low default rate should persist. Absent fresh severe lockdowns, ongoing recovery in the global economy means we would be surprised if the global high yield default rate were to go above 3% in 2022, which even then would be well below the 20-year average of close to 4%.1 The Chinese real estate sector may remain a source of volatility as markets establish how strict authorities will be in tempering debt levels. We continue to believe that, in aggregate, the US as a region offers the most favourable mix of yields and robust domestic economic growth, although European spreads are looking increasingly attractive after recent widening.
While the COP-26 climate conference will be in the rear-view mirror, the route to a more sustainable world remains clear. We expect sustainable debt to remain popular both with issuers seeking to burnish their environmental, social and governance (ESG) credentials and investors demanding their capital is allocated to companies that care about these matters. Our view is that sustainability is a long-term theme of finance and companies that pay attention to ESG are likely to be rewarded with lower cost of capital.
Ultimately, we think that negative real yields across much of fixed income will continue to drive investors into higher yielding parts of the market. Valuations are the element that constrains our positive view as strong demand for high yield bonds means they are no longer cheap. This leaves the market susceptible to periods of heightened volatility, although we would view those as potential buying opportunities.
1Source: Moody’s, Global Speculative Grade trailing 12-month default rate, 31 October 2001 to 31 October 2021.
Coupon: A regular interest payment that is paid on a bond. It is described as a percentage of the face value of an investment. For example, if a bond has a face value of $100 and a 5% annual coupon, the bond will pay $5 a year in interest.
Credit cycle: This cycle reflects the expansion and contraction of access to credit (borrowing) over time. It is related to changes in the economy and the monetary policy pursued by central banks.
Credit rating: A score assigned to a borrower, based on their creditworthiness. It may apply to a government or company, or to one of their individual debts or financial obligations. An entity issuing investment-grade bonds would typically have a higher credit rating than one issuing high-yield bonds. The rating is usually given by credit rating agencies, such as Standard & Poor’s or Fitch, which use standardised scores such as ‘AAA’ (a high credit rating) or ‘B-’ (a low credit rating). Moody's, another well-known credit rating agency, uses a slightly different format with Aaa (a high credit rating) and B3 (a low credit rating).
Credit spread/spread: The difference in yield between securities with similar maturity but different credit quality, eg, the difference in yield between a high yield corporate bond and a government bond of the same maturity. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing spreads indicate improving creditworthiness.
Default: When a bond issuer fails to meet their repayment obligations to bondholders. The default rate measures the percentage of defaulting bonds within the defined market over a set period.
Environmental, social and governance (ESG): Three key criteria used to evaluate a company’s ethical impact and sustainable practices. ESG or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.
High yield bond: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade or speculative grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.
Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high yield bonds.
Monetary policy/stimulus/tightening: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.
Yield: The level of income on a security, typically expressed as a percentage rate.