With a total return of -14.7 percent through September, the Bloomberg U.S. Corporate High-Yield index delivered its worst year-to-date third quarter performance on record. Yields approached 9.5 percent, the highest since April 2020 and near peaks last seen during 2011 and 2016. The environment has reset the opportunities available in fixed income and created many attractive entry points, effectively bringing yield back to “high-yield.”
With credit spreads near 460 basis points (the 56th percentile of historical valuations), the market-implied default rate over the next 12 months is 4.5 percent if we assume 250 basis points compensates for just liquidity risk. We think the default rate could be closer to 3.5 percent, given that it is currently 1.1 percent and the rate increased by an average of 2.4 percentage points in the first year of the three recessions prior to the pandemic. There is already some cushion in the market-implied default rate. However, these views do not rule out further spread widening since once a recession is in full force, expected defaults could rise even further and markets can move into oversold territory as they often do.
In addition to defaults, the next 12 months will likely see a mild downgrade cycle as corporate earnings growth slows and turns negative, given our forecasts for weaker U.S. GDP growth and a likely recession in 2023. For now, however, we remain encouraged by the financial results we see across a large portion of the credit market. High-yield debt issuers are heading into this slowdown with sufficient cash generation to cover annual interest expense at least five times over, and more cash cushion than in 2019 when our strategies were more defensively positioned. Meanwhile, some areas of spread decompression (i.e. a steepening credit curve) are near peaks. For example, B-rated bonds are trading 210 basis points wider than BB-rated corporate bonds, which is the 84th percentile of historical levels and the 96th percentile of the last decade. We interpret this to mean that many single B downgrades are already priced in.
While there may be credit stresses along the way, we believe the default cycle will be less severe than in recent recessions. Given solid credit fundamentals, we view yields and discounted bond prices as offering an attractive opportunity for portfolios to add yield, but investors must remain mindful of downside risks as spreads can widen further depending on how a recession takes form next year.
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This material contains opinions of the authors, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward-looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.
Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk.
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Guggenheim Investments. All rights reserved.
Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.