Experts Believe That Investors Still Receive More Than Compensation For The Risk Of Default
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What opportunities and concerns do you see across them fixed income asset class in 2023?
In our view, the HY bond sector is more resilient than many investors believe, absent a significant negative impact on corporate earnings. Most HY issues won’t need to be refinanced in the next few years, therefore a recession in 2023 with a modest pullback doesn’t overly concern us. As a result, while the investment community focuses on whether spreads are wide enough to justify a move into credit, we see opportunities at current yields, which have shot up to levels not seen for 15 years.
We don’t think spreads are likely to widen significantly, which means we are very comfortable being in the credit space, particularly at such low prices. As a result, we believe it is a relatively straightforward call to add selectively to HY credit at the expense of higher volatility equity holdings which, in a recessionary scenario, should underperform credit.
In a worst-case scenario, investors might experience a difficult economic backdrop in 2023, where inflation remains sticky and leads to a prolonged period of higher rates or further tightening. Those conditions would eventually put pressure on over-levered companies that need to refinance their debt. Under those circumstances, we might engage with the public companies we are already invested in to help them refinance their debt on a private basis. We are less likely to target private middle-market companies because we believe the opportunities for healthy returns in the public markets are currently very attractive, and we wouldn’t be adequately compensated for the illiquidity premium associated with such private investments.
Movement toward higher quality in corporate bonds
Glenn Voyles, CFA
Director of Portfolio Management, Corporate Bonds
Franklin Templeton Fixed Income
Josh Lohmeier, CFA
Portfolio Manager, Investment Grade
Franklin Templeton Fixed Income
Over the past few years, there’s been a reach for yield. With rates rising, and a possible default cycle in the coming year(s) if the US economy falls into recession— what does this look like for sectors like corporate HY?
Glenn: Whether or not the US economy experiences a reces- sion, the actions the Fed is taking to combat inflation are likely to slow economic growth. However, we believe HY corporates are positioned to withstand potential headwinds and deliver attractive forward returns to long-term investors. One reason for our relative optimism is that since the begin- ning of the year, yields within the HY sector have returned to levels benefiting the name of the asset class and are now attractive, in our view. While valuations—measured as the spread over similar maturity US Treasuries—are below levels typically experienced in past recessions, we believe that investors are still more than compensated for default risk.
One reason for this belief is that corporations entered this year in general healthy fundamental shape, with robust interest coverage and little in the way of near-term debt maturities. And so far, at least, companies have been mostly successful in offsetting inflationary cost pressures with price increases of their own, thus maintaining margins. While the default rate will likely increase from the exceptionally low level experienced last year, we believe it will remain below that experienced in past recessions. In addition, with the average HY bond price in the mid-80s,5 the downside in the event of a default is more limited than it is in times when the market is trading closer to par (100). This combination of moderate default expectations and potentially lower default-driven losses leads us to believe that current spreads should be more than sufficient to compensate investors in the years ahead.
Keep in mind that HY has never experienced consecutive years of negative returns, and impressive rebounds have usually followed large drawdowns. Part of the reason for this historical pattern is simple math—with the average HY bond maturing in 5.5 years and with the average price in the mid-80s, there is a strong pull to par for most bonds that will not default. While volatility is likely to persist, with yields near 9% (8.9% as of 11/17/22 index data)6 we think that investors with a multi-year time horizon are buying into the asset class at attractive levels and can generate compelling returns.
