US high-yield bond spreads are close to all-time tight levels, with investors taking confidence from a drop in expected default rates thanks to strong access to capital, government stimulus measures and low near-term debt maturities following heavy refinancing activity.
ICE BofA's high-yield index shows average high-yield bonds offer a spread of 324bp over Treasuries, just 8bp wide of the post-credit crisis low of 316bp seen in October 2018.
Some investors think the market could move even tighter from here, because the proportion of lower yielding Double B bonds in the index has increased since 2018, and many of the more troubled Triple C names have been washed out through bankruptcy and restructuring.
"We're not sure how much tighter [spreads] could go, but there's no catalyst for them to move wider from here. The index consists of more higher quality Double Bs and is longer duration than it has been in the past," said Adam Spielman, head of leveraged credit at PPM America.
ICE BofA's US high-yield index now stands at US$1.56bn, of which 54% is rated Double B. On October 3, 2018 when spreads hit a post-crisis tight of 316bp, Double Bs accounted for 46% of the index.
There are also signs that after a rash of credit rating downgrades last year, upgrades are on the way.
"There is potential for fundamental improvement in credit metrics," said Spielman. "Default rates are going to decline, and the rating upgrade story is pretty positive. I think spreads will stay tight and could move even tighter from here."
Lower defaults
Fitch Ratings on Tuesday lowered its expected 2021 high-yield default rate to just 2.5% from 3.5%, leading to a 2020-2022 cumulative forecast of 9%-11% defaults in the asset class – well below the 2008-2010 three-year cumulative default rate of 22% caused by the great financial crisis.
"Enhanced liquidity, due to access to capital and government stimulus, and low near-term maturities following numerous refinancings since late last year are reducing default risk for many companies that experienced sharply reduced cash flows during the pandemic," said Fitch. "There is a possibility that 2021 default rates end the year in the 1.0%–2.0% range, as a strong economic backdrop should support operating fundamentals for most sectors."
Heavy refinancing activity has kept secondary market spreads in check, despite historically high levels of supply. March was the busiest on record for the asset class at US$59.5bn, according to IFR data. April has continued at a strong pace with US$24.135bn raised in the month-to-date, and as much as US$8.5bn in the pipeline for pricing later this week, according to IFR data.
"The vast majority of new issue volume has been to refinance existing debt, there hasn't been a lot of net new supply," said a second fund manager. "There have been situations where we own the existing bonds that are being refinanced, and we're not loving the price on the new issue, but you can't just get refinanced out and left with cash."
This, and the prospect of lower defaults, is encouraging investors to hunt for better yields in lower rated Triple C bonds, which have outperformed the market in the year so far. ICE BofA's Triple C index has delivered 5.94% total returns in the year-to-date, compared with 1.57% for the broader high-yield market.
"I don’t think the current cohort of Triple Cs is a ‘problem’ cohort, I think they are underrated," said Spielman. "The rating migration trend is positive and a lot of them could be Single B. We also prefer a lot of the credit stories in low Single B or higher quality Triple C credit bands over Double B or Single B, because they are less sensitive to interest rate pressure.”