High yield markets are shrinking

Looking at the trajectory of high yield markets over the past two years, one trend emerges: they are experiencing their most rapid contraction to date. Additionally, most bonds are currently trading at a discount. Since the end of 2021, the ICE BofA BB-B Global High Yield Index has lost $650 billion. The size of the market is down from 2.51trbn$ to 1.86trbn$¹.

Because of higher interest rates and therefore higher costs of debt, many corporates changed their priorities in terms of capital allocation, from M&A and share buybacks to debt reduction.

Charudatta Shende, head of client portfolio management – fixed income, Candriam

We believe this contraction is supported by 3 main factors.

·  Corporate behaviour

Because of higher interest rates and therefore higher costs of debt, many corporates changed their priorities in terms of capital allocation, from M&A and share buybacks to debt reduction. As a result, some bonds maturing are not refinanced with a new issuance but repaid with the free cash flow generated by the issuers, resulting in negative supply for the market.

·  More rising stars than fallen angels

Over the past two years, rising stars outpaced fallen angels significantly. If many companies decided to shift their priorities toward debt reduction, most of the high BBs – the highest rated within high yield markets – went a bit further and even committed to bring their rating into investment grade territories to benefit from cheaper costs of debt going forward.

·  Higher default rates

Some capital structures have accumulated too much debt and are no longer sustainable in the current environment. Both default rates and distressed situations have increased materially from very low levels.

We expect this trend to continue, although at a slower pace.

·  Corporate behaviours are less credit-friendly – After the very strong rally in credit spreads toward multi-decade tights in the US, we start to see some changes in corporate behaviours: M&A, share buybacks and dividend deals from PE owned credits. This should bring positive net supply.

·  Private credit is a new alternative to high yield – Thanks to higher rates, private credit attracted significant capital from investors and can be seen as an alternative to the HY market for issuers, which can result in further negative net supply.

·  Fewer rising stars in the US – We believe rising stars will continue to support technicals materially in Europe while it should be more balanced in the US, a contrasted situation that calls for selectivity.

·  Default rates will remain higher than in the previous decade – We expect a slow but prolonged default cycle as the most indebted companies will gradually have to incur higher costs of debt as they try to refinance their maturity wall in the coming years. Some capital structures in the low single B and CCC are no longer sustainable in the new environment and will have to be addressed in the coming years.

The strong technical background in high yield markets has been exacerbated by the pivot of central banks at the end of 2023 and strong investor demand for credit and high yield.

How can investors navigate in this challenging environment?

Credit dispersion is currently low but we remain focused on fundamentals and prepared for the return of a higher dispersion regime.

Charudatta Shende, head of client portfolio management – fixed income, Candriam

1. Stay focused on fundamentals

Though the backdrop of strong technicals does provide support to the market, it is important to keep a close watch on fundamentals for when the tide goes out. The macro environment remains uncertain and the technicals could turn again in the next months. Credit dispersion is currently low but we remain focused on fundamentals and prepared for the return of a higher dispersion regime.

2. From Beta to Alpha

With credit spreads at multi decades tights, we think it is time to favour active investing.

3. Go Global

In a shrinking market, it is essential for investors to broaden their investment universe and leverage on stronger diversification, additional relative value opportunities and tactical allocation between regional markets.

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The most significant risks of High Yield bond strategies are: Risk of capital loss, Interest rate risk, Credit risk, High yield risk, Counterparty risk, ESG investment risk. This list is not exhaustive and more details on risks associated with investing in high-yield bond strategies are available in the related strategies’ regulatory documents.

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Candriam’s intellectual property rights must be respected at all times and the contents of this document may not be reproduced without prior written authorization. ¹Source: Bloomberg©, ICEBofA BB-B Global High Yield Index (HW40) in USD currency. Data compared between end of 2021 and February 2024.