Boston - Credit markets enter the home stretch of summer sporting both higher yields and spreads than before the COVID pandemic. Notwithstanding a four-month rally alongside capital markets broadly — and in no small part a function of the collapse of yield curves in the US and elsewhere — the income potential in the credit space has widened significantly relative to low-yielding high-grade alternatives. High-yield bonds and loans have rebounded sharply, but opportunity remains.
Opportunity set has become more finely balanced
As we look across the capital structure, high yield has been the standout relative to their senior/secured brethren in the loan market. Large numbers of investment-grade bond issuers have dropped into "fallen angel" territory — somewhat ironically improving the quality mix of the asset class at a time when fundamental conditions remain under pressure from the still-stalled economic picture.
Meanwhile, policy support from the Fed has signaled a backstop for the asset class, and this has in turn emboldened investor comfort with taking risk in the space. High yield has witnessed record inflows, and subsequently record issuance. The combination of these factors has made for a firm and thus supportive technical backdrop, a picture that has also shown itself in the loan asset class, albeit less directly.
Floating-rate loans and high-yield corporate bonds look to have moved from offering outstanding long-term value opportunities in late spring to a more finely balanced opportunity set here in late summer. We think credit positioning and default avoidance are set to play an even more important role in future performance.
When default rates rise, active management can be crucial
While asset prices have risen across credit markets, so too has the default rate — as expected. We anticipate this trend will continue for the rest of the year, likely into the mid-to-high single digits, but much will depend on the degree and speed of the economic rebound afoot, the potential for "second wave" risks, etc.
In any environment but particularly in difficult credit periods such as this one, active management and fundamental bottom-up due diligence are crucial as we continually re-underwrite risk. For example, the high-yield opportunities we are focusing on at present include secured parts of capital structures where loan-to-value remains strong, as well as in fallen angels, particularly those in the energy sector.
Bottom line: Lofty equity markets appear to be discounting a rosy return to our pre-COVID economy, and tight investment-grade bond spreads are sending a similar message. We hope this turns out to be the case, but of course hope is not a strategy. Credit markets are showing more discernment, and this gives us comfort that high-yield bonds and loans may indeed have important roles to play in client portfolios ahead.