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June 09, 2021

Credit Market Update—Look Past the Cover

By Robert O. Abad

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With index yields in the credit market hovering between 3% and 4%, investors may be wondering what value, if any, is left. To us, this is a classic case of “don’t judge a book by its cover.” Credit markets offer plenty of high income and spread compression stories if you look past index yields as your starting point.

The most questions we get on this topic are about high-yield. Over the past year, spreads in the HY sector have declined by over 700 bps to levels that are now lower than the pre-pandemic period. Naturally, this raises investor concerns that HY may no longer have more room to run or that you need reach for lower-quality (riskier) issuers to get yield. We’re not in that camp.

First, it’s important to keep in mind that the high-yield market has become heavily influenced over the years by the surge in passive ETFs. This is a dynamic we covered in a recent blog post, “The Case for Active Management in High-Yield Investing.” To summarize, in their quest to mimic benchmarks, passive ETFs gravitate to the largest and most liquid names (ironically, the largest borrowers). That buying activity causes yields of those issuers, which have the highest weights in HY indices, to compress. This, in turn, has the effect of lowering index yields which, in turn, masks value opportunities offered by plenty of other issuers that are also part of those indices. In other words, we believe the overall yields of the HY indices are somewhat distorted to the downside by the inclusion of those passive ETFs due to their biases toward the largest issuers.

Second, the holy grail of HY bond investing is identifying an issuer whose recovery or ratings upgrade potential still isn’t reflected in its market price. Passing judgment on the quality of an issuer simply by looking at its ratings could represent a missed opportunity. In our research, we find that a number of HY issuers are overlooked and essentially “orphaned” by the market because of their size, liquidity or other reasons that disqualified them from inclusion in HY benchmarks. But these are the very stories that have the potential to deliver attractive returns for investors in both income and total return focused portfolios.

If you look back a year ago, many issuers in the HY market were deemed to be on life support. Market forecasters were calling for double-digit default rates and distressed debt shops were pulling in sizable amounts of investor cash in anticipation of putting that money to work. Fast forward to today and defaults are trending materially lower as many of these “distressed” issuers have clawed their way back through timely refinancing activity and prudent balance sheet management. While the prices of some of these bonds have bounced back from their lows as the US economy inches toward a full reopening—airline bonds are one example—the prices of bonds in many other sectors remain well off their pre-pandemic highs, reflecting a “wait and see” stance by the market.

For instance, we currently see good value in both senior secured and unsecured bonds in the leisure sector where certain issuers are yielding between 5% and 8%. Select issuers in specialty retail stores (e.g., arts and crafts, pet care, etc.), consumer services and the pharmaceutical sector also offer yields in the 5% to 7% range. The energy sector, which has had its share of volatility, continues to claw back from its 2020 lows. In this area, we’re focused on exploration and production names with strong management teams, well-situated oil fields and continued access to the capital markets. Yields in this segment of the energy sector range between 5.5% and 7%.

We find similar value opportunities in the bank loan space. This is an asset class that continues to remain attractive as loan spreads are north of 400 bps after declining as low as 356 bps in early 2018. In our view, there’s still more room for bank loan spreads to tighten, and there’s no real interest-rate risk to cause spreads to widen given the floating-rate nature of those securities. From a credit risk standpoint, we don’t see any significant defaults on the horizon as the default rate over the last 12 months continues to fall—it’s currently sitting at 1.7%, well below its long-term historical average.

Digging deeper, we believe single B rated loans offer more attractive yield than the broader market. They continue to outperform the rest of the field and we expect that trend to continue in the near term. We especially like second-lien loans to companies where we have high conviction around fundamental performance. These loans typically come at LIBOR + 750-800 bps, have a LIBOR floor of 0.75% (which provides some buffer should interest rates move lower) and offer yields in the 9%+ range. If we look to the collateralized loan obligation (CLO) market, which we view as a close “cousin” of the bank loan market, BB rated CLO tranches provide yields reflecting LIBOR + 675-800 bps. These levels are particularly compelling in an environment where the default rate of the loan asset class remains low and is trending lower.

In an environment where investors are cautious about interest-rate risk and the uncertainties related to the ongoing pandemic, we recognize that they may also be wary of the low headline yields prevailing across credit markets. However, focusing primarily on index yields can be misleading as they mask the diversity of value opportunities currently present and fully exploitable across and within the credit universe.

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