Macro Markets Podcast Episode 54: Make Room For High Yield

Dan Montegari, Head of Research for our Corporate Credit team, and John Walsh, Head of High Yield Trading, discuss credit spreads, default rates, market technicals, and other factors driving their team’s constructive views on risk and opportunity in leveraged credit. 

June 14, 2024


Macro Markets Podcast Episode 54: Make Room for High Yield

Dan Montegari, Head of Research for our Corporate Credit team, and John Walsh, Head of High Yield Trading, discuss credit spreads, default rates, market technicals, and other factors driving their team’s constructive views on risk and opportunity in leveraged credit.

This transcript is computer-generated and may contain inaccuracies.

Jay Diamond: Hi everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of thought leadership for Guggenheim Investments, and I'll be hosting today. Tighter monetary policy has weighed on the U.S. economy, and we have started to see some downside surprises in some of the recent data, but a broad recession has thus far been avoided, primarily due to fiscal spending associated with the post-COVID recovery. Now, the stimulus has helped to create a resilient consumer and fortify corporate balance sheets. The shifting outlook for fed policy has injected some volatility into the market, but when the Fed is on pause, it's a good time for active fixed income management to shine, which leads us to today's episode. We are joined today by two of the leaders of our corporate credit team, who are here to talk with us about the high yield market. Dan Montegari is Head of Research and a member of the Investment Committee for Corporate Credit. And John Walsh is Head of High Yield Trading and on the portfolio management team for the Guggenheim High Yield Fund. Welcome, Dan and John. Thanks for taking the time to chat with us today.

Dan Montegari: Hey, Jay. Thanks for having us on.

John Walsh: Hey, Jay. Thanks for hosting.

Jay Diamond: Well, let's discuss some of the major themes in the high yield market today. And Dan, let's start with you. What are some of the big themes that you are watching develop?

Dan Montegari: I would say what we've been watching develop over the past 18-to-24 months is businesses adapting to post-COVID normalization. When you kind of think about the stages, you had the pandemic, which was a dramatic shock, you had the fiscal and monetary policy response, and now what you've got is kind of a normalization from that policy response. And we've seen that normalization, I would say in three areas of the market. It's been in supply chain, and I'll include labor in that supply chain; monetary policy, we've gone from QE to QT, we've gone from low rates to high rates; and then really consumer spending, we've gone from a lot of goods purchasing shifting to services. So, there's been this normalization process happening across those three broad buckets. We've seen it impact sectors in a variety of ways and at different times and at different ways. I think you Anne Walsh on the podcast back in January, you talked about the concept of rolling recessions, and really that's what we've seen. We've seen businesses and industries be impacted in different ways at different times. When one's recovering another is drawing down. Bringing it back to the high yield market, when you look at where default rates are when we talk about a rolling recession, we're at 2.2 percent. That's well below kind of the long-term average of 4 to 5 percent, and the reason for that is high yield came into the market with a big margin of safety. If you look at where credit metrics were, interest coverage was at all-time highs. Net leverage was much lower than it has been historically. So, it came into this normalization in a very strong position, and obviously as that normalization has occurred, the market's been able to absorb that. We have seen some deterioration in metrics. Still overall relatively healthy, but I would say our job as the research team is to understand where we expect to see that continued deterioration and where we expect credits to kind of stabilize and improve.

Jay Diamond: And we're going to dive into some more of those topics a little bit later on. But, John, what are some of the big themes that you are seeing right now?

John Walsh: Well, Jay, some of the themes that we're seeing in the high yield market now is robust issuance and spreads trading in range. In fact, if you look over the last two months, high yield spreads have been on a narrow 25 basis points band, but really have tightened since year end. We've seen inflows into the market and generally below average trading volumes. I would also say most of the trade is being done by ETF arb accounts and hedge funds, as real money accounts are holding above average cash positions and are searching for opportunities. I think the real money accounts are finding their opportunities in the primary market, as well as the off-the-run, maybe a little less liquid secondary market, which is where Guggenheim excels because of our deep dive thorough research we employ when investing. Performance in high yield has been strong, with high yield returning almost 13.5 percent in 2023 and up almost 2.25 percent for the first five and a half months of the year so far.

Jay Diamond: John, let me just follow up with you here. So, you're the head of high yield trading, and you've got your finger firmly on the pulse of the market. So, tell us a little bit more about the technicals. What are you seeing in supply in the high yield market?

John Walsh: As I mentioned, issuance has been strong in high yield. In fact, last month we had 31.5 billion of issuance, which was the busiest month of issuance in almost three years since September of 2021. So far this year, we've seen issuance of $150 billion, which is up over 80 percent from this point last year and represents 85 percent of the total $177 billion issued in all of 2023. Some interesting facts about that issuance is about 80 percent of that issuance has been for refinancing, and then about 50 percent of that issuance has been of secured paper. So, people looking for higher quality, secured-type paper. Demand for the new issues had been strong, with most deals being multiple times oversubscribed and therefore pricing at the tight end, or through the tight end of the original guidance, but still trading well on the break. Trading volumes, I would say, have been below normal daily trading volumes and driven by those fast money accounts that I mentioned earlier, ETF arb accounts and hedge funds, as they look to take advantage of the volatility we've seen in rates. The 5-year Treasury has traded in an almost 100 basis point band this year alone, trading out of a low of 380 back in early February and as high as 472 in late April. Just last month we saw the 5-year trade at a 35 basis points range. So, that volatility is what’s causing the fast money to get involved and be the most active trading accounts. Real money has been more focused on the opportunity of the primary market and the off-the-run secondary market, a little less liquid that might have a bigger liquidity premium to it. Fund flows have been strong for a yield over the last seven weeks. We've seen over $7 billion come into high yield, and 85 percent have been going into ETF related accounts. Overall, issuance has been met with strong demand, and any sort of back up in high yield has led to better buyers emerging.

Jay Diamond: And what do you think accounts for the increase in secured issuance?

John Walsh: I think that's what investors are demanding in order to participate in the deals. In order for the deals to be attractive with the higher interest rate environment, a secured piece of paper allows you to issue at a lower interest rate, so companies want to issue as low as possible. And then the investors are demanding that security in order to make their investment.

Jay Diamond: Now, Dan, I want to talk about fundamentals with you, but before we dive in, tell us a little bit about the credit research process that you oversee here at Guggenheim. How is it organized and how is it differentiated from some of your peers?

Dan Montegari: Our credit research process at Guggenheim is very bottoms up. It's fundamental. I mean, really what we try and do is focus on the economic characteristics of the businesses, the amount of cash flow that they generate, and really what's important is the sustainability and the predictability of that cash flow. There's a lot of factors that go into assessing sustainability and predictability of cash flow. It's the value add of a business, it is how embedded that business is with their customers, the capital intensity of that business, barriers to entry within the industry that it operates in, and so there's a lot of factors that go into our analysis of predictability and stability. Ultimately, that will drive our determination of the amount of leverage that a business can sustain. And then when we look at our margin for error, we're looking at kind of loan-to-value. So, we want to know the amount of debt relative to the enterprise value. All else equal, we want to keep it lower to generate a nice margin for safety and some cushion as things inevitably will go off track sometimes.

Jay Diamond: What is your view right now on corporate credit risk?

Dan Montegari: It's kind of tough to put corporate credit risk into a general basket. If I take a step back and I look at the high yield market, just throwing out some stats, it remains relatively healthy. If I think about total leverage, leverage is about 3.7 times. I kind of compare that to the long-term average of about 4, so below the long-term average. if I think about interest coverage, we're in the mid to low 4s versus historical averages. In the high 3s. I mentioned the default rate in the low 2s versus 4 to 5 historically. So overall, I would say the market is relatively healthy from a metrics perspective. But I think the reality of the market is there are idiosyncratic situations, and part of the research team is to really dig in and do a deep dive and understand those idiosyncratic situations and opportunities. Two examples of businesses within the same industry, if you think about legacy airlines, Delta, United, and American Airlines all operating in the same industry, but United and Delta doing relatively well while American is struggling because of some corporate decisions that they've made in terms of go to market. Same thing with Avis and Hertz, rental car businesses operating in the same industry, but Hertz is really struggling because of some of its strategic decisions as well. And so, it's tough to broadly paint corporate credit, but from a metrics perspective, relatively healthy, all else equal. 

Jay Diamond: So just to follow up, you mentioned the rolling recession concept that Anne Walsh had brought up in a prior episode of our podcast, so which sectors right now are faring well with higher borrowing costs and which industries and company types do you think are hurting more than others?

Dan Montegari: You mentioned interest rates. I think borrowing costs and interest rates are when we go back to kind of the three buckets of normalization that we've seen--supply chain, monetary policy and consumer spending--I think monetary policy is one that affects every single business that we look at. So, interest rates have definitely impacted every single asset class. I think the surprising thing when we look at which sectors have performed relatively well, it's not as straightforward or as intuitive as you would think. Surprisingly, homebuilders who historically have been overexposed to rates and historically negatively correlated to rates, if you look at the HomeBuilder ETF in the first quarter of 2024, it kind of hit all time highs. And so, it's because you've got a supply/demand imbalance, as rates went up, the level of existing supply went down, and as a result you had homebuilders who were relatively conservative coming in and are able to step in and fill that void. So overall, that's a sector of the market that's seen some health. That's maybe counterintuitive to what we would have expected from a sector that's seen its challenges. We've seen cable and telecom have really been challenged sectors. There are some structural issues going on within cable and telecom. If you think about cord cutting, that's been a big focus and a big theme within that market. So, there's a structural demand challenge. And then if you think about competition, you've seen a lot of competition from fiber over builders who are competing for a broadband customer. And so as a result of competition, you've seen cable and telecom have to spend a lot of CapEx to invest in their networks. They're investing in their networks when interest rates are high, and their balance sheets were relatively levered coming in. So that's an area of the market that we've seen a lot of pain and a lot of challenges in.

Jay Diamond: Well thank you. Now John, you mentioned at the top that spreads are tightening. Put this in context for us. How tight are they and where are they coming from?

John Walsh: Sure. Currently the spread on the high yield index is just wide to 300 basis points, which is well inside the historical average of about 450 basis points or so, but still wide to the all-time tights of about 224 basis points back that we saw in the 07-08 timeframe. Now while the spreads are inside the historical average, the absolute yield is right at about the historical average of 8 percent. Normally, you would see credit spreads widening with deteriorating credit conditions and tightening during improving credit conditions cycles. Tightening that occurred over the last two years has been the combination of both interest rates moving higher and the credit quality of high yield improving, as we talked about with the new, the almost 50 percent of the new issue market has been secured paper. The current default rate as well is near the lows, right around 2.3 percent, which is low compared to the historical average -- Dan mentioned earlier 4 to 5 percent. And since the beginning of February, we've been stuck in a narrow range of about 50 basis points spread between 275 and 325. And I mentioned earlier that we were in just a 25 basis point spread over the last two months or so. Back in early 2022, high yield spreads were 550 basis points, and as the Fed started the hiking cycle from the zero interest rate environment that we saw, we saw high yield spreads start to tighten in. Then currently, whenever we see the absolute yield at around 8 percent as we have now and spreads inching back towards 350 in this current environment, we see buyers emerge for high yield on any sort of weakness. The Dealer recently wrote a report suggesting that the absolute yield on the high yield index is actually understated by 25 basis points. The reason for that being is a considerable amount of the current market was issued in the low interest rate environment back in 2020 to 2022. We had interest rates on issuers in the high 2s, 3 percent range, trading a deep discount now, and typically they get taken out a year before maturity or so. So, their contention is the yield on the high yield market is actually 25 basis points higher than what you're seeing in just the computation of around 8 percent. And although the expectation for Fed rates have been pushed out and cut from a high of six rate cuts in 2024 to just two, accounts still feel the Fed is close to starting a rate cutting cycle, and the absolute yield on high yield is attractive. Part of the reason for this comfort level, again, is the quality of issuance in the high yield market, which is in an improvement. And currently 50 percent of the overall market is rated BBs. BBs currently yield around 6.60 or so, which is attractive versus the historical average of the last 20 years of down around 6 percent. And in fact, there is an expectation that the Fed is going to start cutting later this year makes those BBs even more attractive.

Jay Diamond: So in general, though, what is the market telling us when spreads are tightening?

John Walsh: Spreads tighten in an improving credit cycle generally. And part of this tightening that has occurred is definitely because of that, but part of it is because of rapid increase in rates as well. So as rates will fall back down, we might see a little widening in spreads, but it will be attractive still because of the credit quality.

Jay Diamond: You mentioned yields before, are opportunities in the market today accretive to what's in a portfolio of bonds that's been held for the last couple of years, bought at much lower rates?

John Walsh: Yeah, I believe so, especially as we see a bunch of these companies get refinanced. They're high quality companies, their paper might be only yielding somewhere in the 6 percent range, and now when they have a new issue that goes a little further out the curve for that duration, they have to pay up a little bit. So, the issue may be 50-75 basis points above where their current issue is trading. So, there is a new issue discount as well when a new issue comes to market for an issuer.

Jay Diamond: Dan, John just talked about spreads tightening. Do you think investors are being compensated for the risks they're taking?

Dan Montegari: So, let's take a step back and think about what the spread represents. Spread is compensation for uncertainty, and in the corporate credit world that uncertainty is related to default risk. So, as we've seen spreads compress, the market is effectively saying that default risk has declined. From our perspective, we look at default risk on an issuer level basis. We do deep dive fundamental analysis to really understand whether we're being compensated for that incremental risk that we're taking in an issuer. We don't necessarily compare spreads to each other because each business is different and spreads between two different businesses should be reflective of the underlying borrower. So, just because a business is trading at, call it, 300 basis points versus another business at 600 basis points, the compensation level might not be adequate at 600 basis points, but it might be adequate for that business at 300 basis points. So really, it's getting the underlying credit underwriting right, and that's really the compensation that we get for taking on the incremental corporate credit risk.

Jay Diamond: When you're coming into the market, are you finding spreads at levels that are compensating you for the risk?

Dan Montegari: I think on an absolute yield basis, we are definitely being compensated for the risk, but it really comes down to, again, credit selection and underwriting. Like I said, that spread differential is really supposed to be compensation for default risk, and so our job is to analyze that default risk within the issuers in the context of a market that has, on an absolute basis, a yield profile that's higher than historical averages.

Jay Diamond: Where are you and your team finding value right now and what are you avoiding?

John Walsh: So overall, we're finding value in the new issue market, but we're being very selective. We've only played, I'd say, less than 25 percent of all new issues that have come to market so far this year. There's probably been about 200 of them, so we've only played about a quarter of them. We also have been finding value in off-the-run, a little less liquid, or other accounts don't want to do the research and the work, whereas they're more happy to just try to index themselves. We do deep dive credit research to get kind of under the hood and make sure we know what we're investing in, and when we choose it, we like it. We are avoiding kind of highly cyclical companies or industries that cycle hard. I'd say we're underweight leisure and traditional energy. I'd say in general, we prefer secured paper over unsecured paper. And with spreads compressing, we've seen this dynamic where accounts looking for increased yield have compressed the spread between unsecureds and secureds to levels where, when they came at issue, there's a 100 basis point spread. We've been doing some swaps where we've been selling unsecured paper going into secured and only giving 25 basis points. So if you think of the uptick in quality that you get for only giving 25 basis points versus where it came when it was a 100 basis points. I would say overall, we work very hard to identify attractive investment opportunities in both the new issue and the secondary market.

Dan Montegari: It's kind of counterintuitive to some extent. as spreads get tighter, I think the market would imply default risk is lower, but really that's when you need to do your credit work and really be sure and confident in the money that you're putting to work, because your margin for error is lower. And so, when we're doing our analysis, as John said, we're being much more selective in what we're picking. And even though spreads are tighter than they've been historically, the dollars that we're putting to work are on businesses that we feel highly confident in the ability to receive our coupon and ultimately paying off and receiving an attractive return on that investment.

Jay Diamond: Any specifics on industry or company types that you're finding value in and or avoiding?

Dan Montegari: And we're definitely avoiding relatively high capital-intensive businesses, especially in a high-rate environment. I think we talked about cable and telecom are areas we’re avoiding. I think generally where we've been putting money to work is, again, businesses and services that have highly recurring and predictable revenues that we can effectively underwrite. And then generally, it's kind of a hodgepodge. There's no sector I would say we're actively over or actively underweight. I think we're assessing opportunities on a credit-by-credit basis, regardless of sector. We're looking at every industry, we're doing deep dives, and there's not over or under weight one specific industry or a view from a Corporate Credit Committee Perspective.

John Walsh: But I would think that we do tend to avoid highly cyclical names. Names that cycle hard, boom and bust like in energy.

Dan Montegari: We do. Yeah. Absolutely. And just going back to kind of the thought process, I mean generally cyclical businesses, there's a lot of volatility in those cash flows. They're very difficult to predict. And just because a business is cyclical doesn't mean it's bad. As long as you have the margin for safety in terms of a lower LTV relative to the enterprise value. And we're definitely avoiding cyclical businesses where we feel like the loan to value is above what it should be. But just because a business is cyclical doesn't necessarily mean we will avoid it. If we're being compensated, and the capital structure is appropriate, we will play.

John Walsh: Yeah. No, that's a very fair point.

Jay Diamond: Dan and John, thank you guys so much for your time. I really appreciate it, but before we let you go, Dan, do you have any final takeaways that you'd like our listeners to have?

Dan Montegari: I would just say at Guggenheim, we take a very fundamental and bottoms-up approach to credit underwriting. We think credit selection will drive outperformance over the long-term. I think when we look at the high yield market today on an absolute basis, yields are attractive. And I would say the team is hard at work identifying opportunities to put money to work in a market on an absolute basis that we view as attractive.

Jay Diamond: Thank you, Dan. John, any final words from you?

John Walsh:  Our deep dive research process allows us to focus on credit selection opportunities that others might pass over because, as Dan said, we believe credit selection is tantamount in the investing process. In closing, I like to thank you, Jay. I would like to thank everyone for tuning in to this podcast, and stay tuned for more Guggenheim podcasts. 

Jay Diamond: Again, thank you, Dan and John for coming. I really appreciate it. And please, I hope you come back again and visit with us soon. And thanks to all of you who have joined us for our podcast. If you like what you're hearing, please rate as five stars. If you have any questions for Dan, John or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond. We look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, including our High Yield and Bank Loan Outlook and our Corporate Credit Quarterly Insights, please visit us at guggenheiminvestments.com/perspectives. So long!


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