The term “fog of war” is a loose interpretation of a phrase coined by 19th Century Prussian military analyst Carl von Clausewitz. The phrase is used to describe the complexity, confusion, or chaos experienced in military conflicts. While there is no comparison between the horror of military conflict and investment management, fixed-income investors are nonetheless engaged in their own battle to find direction for the remainder of 2022.
High Yield bonds have been reasonably well behaved despite the first half of 2022 being the worst six-month period for fixed income since 1788, according to data analyzed by Deutsche Bank1. The ICE BofA High Yield Index median Option-Adjusted Spread (OAS) barely rose above its 25-year average of 444 basis points (bps) and was only higher for a short time so far this year.
Why such a muted response in high yield credit while other areas of fixed income and equity markets came under pressure? We believe there are a few key reasons for this.
- The summer has been slow and trading volume is low. High Yield issuance has fallen 75% YoY which limits investors’ ability to reinvest coupon, maturity and call tender proceeds.
- The energy sector has been relatively strong. Energy makes up approximately 13% of the high yield index, and the sector is trading about 60 basis points (bps) tight on a spread basis relative to the broader high yield market.
- A potential recession has not been fully priced into the high yield market.
We at Hotchkis & Wiley do not believe a recession is imminent, but clearly, the odds of a recession have risen in recent months due to an increasingly aggressive Federal Reserve. While we have had two consecutive quarters of economic contraction as measured by Gross Domestic Product (GDP), the US labor market and consumer balance sheets continue to be quite strong. If we do fall into a recession, we expect that it will be shallower than the Great Financial Crisis and COVID-driven recessions, and more in line with the recessions of 1991 and 2001. However, the biggest risk to the high yield market is that inflation remains sticky, prompting the Federal Reserve to continue its aggressive interest rate hikes.
Where does the high yield market go from here? This is a difficult question to answer but there are reasons to be optimistic.
- The debt maturity profile in high yield looks well-extended. Less than 10% of the high yield market has debt maturing in the next two years which we believe could help mitigate default risk should a recession occur.
- Commodity and housing prices have fallen off their highs of the year. So far in Q3, WTI Crude is down 21%, gasoline is down 36%, and most industrial metals and many agricultural product prices are lower which should tamp down inflation expectations. As a result, we have seen the high yield OAS move from a high of 599 bps on July 5th to about 500 bps today2.
- Investors are receiving an attractive coupon in the current environment. 75% of high yield return comes from the coupon, with the remainder coming from price appreciation. The dollar price on the high yield market is currently about $90, so investors have the potential for $10 of price appreciation on top of the roughly 6.5% coupon.
Overall, our high yield outlook remains constructive. While we do see margin pressures and lingering supply chain disruptions having an impact on credit fundamentals, our assessment of credit technicals and valuations has improved. Recession fears are likely to ebb and flow over the coming months as inflation and economic data are closely parsed by the market. Should the path of inflation stay elevated for longer the Federal Reserve will be compelled to maintain its aggressive policy stance – a scenario that will likely lead to wider credit spreads. In the meantime, high yield investors can expect to receive an attractive coupon for a portfolio of bonds trading around $10 below par value. Our job as an active investment manager is to provide clients with a high-quality portfolio that seeks to have fewer credit mistakes than our competitors and the broader high yield market. After all, we believe the key to success in high yield investing is to avoid companies with poor credit fundamentals.