Yes. The combination of rising interest rates and a deteriorating earnings outlook is likely to generate ample negative headlines about credit in the months ahead. Rating agency downgrades will accelerate and defaults will rise. The flipside is that some of this is already in the price and many borrowers are prepared for these headwinds. Investors should look beyond passive index-like exposure and consider credit opportunities funds for whom the opportunity set continues to expand.
As 2022 comes to an end, the macro backdrop doesn’t look supportive for credit or most other risk assets. Economic growth is slowing and expected to weigh on earnings, while the Federal Reserve looks likely to continue hiking and debt service costs are increasing. New issue markets have been highly discerning in recent months, and the cost of financing for deals like buyouts has risen enormously from both a spread and base rate perspective.
The combination of this backdrop and higher debt levels facilitated by prior prevailing conditions (e.g., weaker loan documentation, previously low yields) will prove problematic for some companies. Rating agencies expect default rates for high-yield (HY) bonds and loans to rise next year, and some companies will struggle to refinance previous debt issuance, given weaker earnings and lower valuations. And with inflation elevated, any downturn in credit markets is less likely to see the Fed ride to the rescue this time around.
Distress and defaults will rise, and a vulnerable tail of borrowers exists, but there are some buffers. HY companies are entering this downturn in decent shape. US HY index net leverage was around 3.4 times at the end of third quarter, a full turn lower than prior to the COVID-19 pandemic. Similarly, elevated interest coverage (EBITDA/interest of nearly 5.5 times) leaves the average HY borrower significant cushion for earnings to deteriorate from here.
Technicals are also surprisingly strong for higher beta credit. New issuance of HY bonds has plummeted in 2022 and the number of HY issuers that upgraded to investment grade has vastly outpaced the number that moved in the other direction. The combination of these dynamics with existing bonds being repaid is that the HY index has shrunk over 10%, helping cap spread widening. With few bond maturities on the calendar in 2023 and prospects for some industries (e.g., energy) and specific credits surprisingly bright, the supply/demand balance should continue to remain favorable.
The current low level of defaults can be explained by strong balance sheets and limited refinancing needs, as well as the lagged effect with which recent rate hikes will be felt throughout the economy. Defaults will rise over the course of 2023, but some of this is already priced in. The HY index spread (464 basis points) is only slightly above its historical median and well below the level typically seen during recessions. However, with CCC-rated bonds trading around 75 cents (a level last seen in March 2020 and before that the summer of 2009), there is some cushion if default rates rise further from current subdued levels so long as the next recession is not a multi-year event.
Either way, the opportunity set for distressed funds is already large. Currently over $110 billion of HY bonds trade at dollar price at or below 70 cents, and $130 billion of loans trade below 80 cents. Some of this simply reflects higher base rates as coupons on this paper is low. However, in other cases prices reflect elevated default risk and some managers will fare better than others in negotiating higher recoveries. Further, if new issue markets remain difficult and highly leveraged companies find refinancing costs untenable, skilled credit opportunities funds will be able to craft solutions (i.e., rescue finance) that result in attractive spreads plus opportunity to participate in equity upside.
Credit investors may face stiff cross currents in the months ahead, but we believe those able to employ skilled managers may reap attractive rewards.
Wade O’Brien, Managing Director, Capital Markets Research