Prudent fiscal management isn’t the only reason the corporate universe is well positioned. The default cycle triggered by the pandemic—with defaults peaking at 6.3% in October 2020—effectively cleaned up the sector. The weakest companies defaulted and are now no longer part of the investable universe. Only the strong survived. That was less than three years ago. Since then, there simply hasn’t been enough time for the survivors to develop unhealthy financial habits.
The pandemic-led wave of defaults and downgrades boosted the average quality of the high-yield market. Even as many of the lowest-rated high-yield bonds defaulted and fell out of indices, many of the lowest-rated investment-grade bonds fell into the high-yield market as fallen angels. Consequently, the quality of today’s high-yield market is unusually high, with BB-rated bonds comprising 49% of the market, versus 43% on average over the past 20 years.
Since the start of the pandemic, companies have also alleviated financial pressure by extending their maturity runways. That means there’s no approaching maturity wall, where a large share of bond issues matures and issuers are compelled to procure new debt at prevailing rates. (Today, the average high-yield coupon is 5.9%—significantly lower than prevailing yields, at 8.5%.) In fact, only 5% of the market will mature by the end of 2024, with most maturities coming between 2027 and 2033. Gradual and extended maturities slow the impact of higher yields on companies.
As a result, we expect a moderate default rate for the next 12 to 18 months—around 4% to 5%. What’s more, the share of the high-yield bond market that is secured—31% as of December 31, 2022—is high by historical measures, which may translate into higher recovery rates in the event of default.
That said, we think investors should favor higher-quality credits, be selective and pay attention to liquidity. CCC-rated credits—particularly those in cyclical industries—are most vulnerable in an economic downturn and represent the lion’s share of defaults. Yield spreads for CCC debt also tend to widen more dramatically than those of higher-quality bonds—about three times as much, in our analysis. Debt rated B and BB may be a better choice in today’s environment.
High-Yield Bonds at Bargain Prices
Yields on high-yield corporate bonds are higher today than they’ve been in years, giving income-seeking investors a long-awaited opportunity to fill their tanks. And because yields are so high, bond prices are extremely low, contributing to a compelling convexity profile. When bonds have high positive convexity, their prices rise more than would be expected as interest rates fall, and their prices fall less than would be expected as rates rise.
In fact, at less than $90 today, average bond prices have rarely been lower (Display). It would take an extreme shock to push prices much further down. Because bonds eventually mature at par, prices are much more likely to rise from today’s bargain levels than to fall further. And if bond prices do fall, ample yield levels would cushion the effect.