Investor obsession with peaks—peak inflation, peak hawkishness, peak bearishness—has shifted to pivots, in particular a possible Federal Reserve (Fed) pivot away from its aggressive rate hikes over the last year. We see that pivot as a three-stage process: downshift, pause, and then rate cuts. The downshift began in December when the Fed hiked 50 basis points after four consecutive 75-basis point hikes. As we write this article, financial markets are discounting 2 to 3 additional 25-basis point hikes during the first half of the year and then a pause. The Fed seems comfortable with this pricing. However, financial markets also are discounting a shift to 50 basis points of rate cuts in the second half of the year and another 100 to 125 basis points of cuts in 2024. The Fed has done nothing to validate the discounting of these rate cuts.
Immaculate Disinflation with Rate Cuts
Financial markets seem to be placing a higher probability on what some are calling an “immaculate disinflation.” This phrase describes a return of inflation to around 2% over the next year, accompanied by a soft economic landing or perhaps a mild recession with only a modest increase in unemployment. The best scenario for a wide range of financial assets would be an immaculate disinflation with Fed rate cuts in line with current market pricing. Disinflation alone is not enough; the rate cuts are essential to this scenario.
Another scenario is that there is already enough monetary and fiscal tightening in the pipeline to lead to a recession over the next few quarters. This outcome does not seem to be priced into a range of financial assets, and those promoting this scenario are most bearish on risk assets like stocks and high yield corporate bonds. We call this “imminent recession.”
Long Pause: Our Base Case
We think the financial markets are underpricing the scenario that the Fed is telegraphing, which we will call the “long pause.” We understand the Fed often does not know when it will cut rates; it also may have good reasons not to communicate its intentions well in advance. However, we expect this cycle to last longer than the markets are discounting. Furthermore, despite every Fed official saying recession is not in their base-case forecast, we believe the Fed would rather see a recession than risk a premature declaration of victory on inflation. If a recession does materialize, the Fed could then implement well understood tools. Otherwise, they would be trying to restore their credibility after two major inflation-related policy errors.
Carry Is Key in a Long Pause
During a long pause, yield—otherwise known as carry—may be the most important source of return and is where the high yield asset class shines. In the U.S., the yield has been in the 8-9.5% range for much of the time since mid-2022.
Since the middle of last year, the environment has not been that of a long pause as both actual and expected Fed hikes have increased materially. However, the timing and level of a pause has increasingly been discounted by financial markets, so it is constructive to see how high yield has performed compared to other asset classes since June 30, 2022 (see Figure 1).
As we potentially head into a long pause environment, which the Fed has repeatedly emphasized, we believe an actively managed approach to high yield is imperative. Active management will be an important and appropriate strategy for this type of scenario, both for taking advantage of the carry and for steering away from potential defaults.
Outlook for Defaults
We believe the default experience in the next recession will be more like the recession scare of 2015 – 2016, with roughly half the cumulative defaults of the 2002 and 2008 recessions. The most bearish forecasts for high yield defaults are invariably based largely on history with minimal analysis of the current environment. We believe one of the most important but overlooked factors is that managements of high yield issuers have had almost a year to prepare for a higher cost of capital and a potential recession. They may have several more quarters, at least, to continue to prepare. We want to make sure that managements have the proper sense of urgency to adjust to this new environment. While the cost of capital is clearly much higher, creative CFOs who want to access capital have a number of avenues to do so—whether in the unsecured or secured part of the high yield market, leveraged loans, private credit, convertible bonds, or public or private equity. Managements also have a rare opportunity to retire existing bonds well below par with the U.S. high yield market priced below 90 cents on the dollar. Finally, we just went through a default cycle in 2020, so the weakest credits have been restructured or eliminated from the high yield market.
Now, we will show how different the U.S. high yield market is today compared to history. Interest coverage is at record levels because a majority of the high yield market was financed in 2020 - 2021 at very low coupons with extended maturities (see Figure 2). These low-coupon, fixed-rate obligations are being serviced with inflated assets and cash flows.
The same dynamic can be seen when comparing the recent growth of corporate earnings before interest, taxes, depreciation, and amortization (EBITDA) to declining debt levels (see Figure 3).
The high yield market has been relatively stable in size over the last eight years while leveraged loans, and particularly private credit, have exploded (see Figure 4). More of the aggressive financings of smaller, private equity-sponsored or privately held companies takes place in leveraged loans and private credit. Meanwhile, the credit quality of the high yield market has migrated higher with larger issuers that are more often public companies (see Figure 5).
Private credit has been active compared to the leveraged loan market in financing leveraged buyouts (LBOs) over the last four years (see Figure 6). This trend is reminiscent of the aggressive LBO financings in the years before the Global Financial Crisis that ultimately struggled or defaulted.
Finally, as discussed above, because so much financing was done in 2020 and 2021, high yield issuers have limited maturities to address in 2023 through 2024, less than 10% of the market (see Figure 7).
Additional Reasons Why Spread Widening Is Expected to Be Contained
Some expect the high yield market to reprice to the spreads of prior recessions or recession scares. In addition to the fundamental differences in today’s market, investors know what a windfall those prior buy points created. In 2020, the Fed in partnership with the administration and Congress set up facilities to directly support the high yield market by, among other things, buying high yield ETFs and certain high yield bonds. We expect opportunistic capital to come into the high yield market at lower spreads, and that has been the case of late. We believe this trend is why the market has remained in a spread range between 400 to 600 basis points for the last nine months when some pundits, who are not focused on the current state of the market, have been calling for much wider spreads.
We think a long pause on the part of the Fed is the most likely scenario but one that is underpriced by the financial markets. In this type of environment, during which the Fed maintains higher rates for longer before easing, we contend that looking for carry while steering away from defaults is a good strategy. Managements have had and will continue to have time and access to capital to prepare for a higher cost of capital and potential recession, lowering default and other risks. Furthermore, the fundamentals of the high yield market remain supportive, justifying much narrower spreads than we have been accustomed to historically, even in the imminent recession scenario. Lastly, inflation is good for credit quality, particularly when so many issuers have locked in fixed-rate, low-cost, long-term financing. With yields at attractive levels, high yield continues to offer a compelling opportunity.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.