High Yield Looks for a New Year Resolution
Last week appeared to solidify the market consensus that inflation and US rate hikes will both slow in the year ahead, but for credit investors one remaining area of uncertainty is the trajectory of default rates. The latest baseline forecast from Moody’s sees the high-yield corporate default rate rising from 2.5% in October 2022 to 4.5% by October 2023, although its full scenario analysis envisages a range from 3.8% under optimistic assumptions, all the way to 14.6% on a severely pessimistic basis.1
One historically leading indicator of default rates is the Federal Reserve’s Senior Loan Officer Opinion Survey (Figure 1), which in essence asks banks whether they are tightening or loosening lending standards. As the chart shows, it tends to start rising (signifying tighter standards) significantly before recessions and defaults peak. The next data point from this quarterly survey will be released in January; the line’s height then may help resolve that outstanding question on where default rates go.
For now, after high yield’s recent rally, the five-year cumulative default rate implied by credit default swaps has come down from 14% at the start of December to circa 6% in the US, assuming a 40% recovery rate.2 One reason why defaults are unlikely to spike to prior recession levels, in our view, is that many companies have termed out debt well into the future and the upcoming maturity over the next few years seems manageable. Another factor pointing to a more muted default backdrop is the better underlying fundamentals for the asset class going into the end of the credit cycle.
One area that we believe could suffer higher defaults, however, is high yield’s close cousin – leveraged loans. Leveraged loans face deteriorating fundamentals, in our view, as the impact of higher interest rates bites immediately into overly levered capital structures that were constructed with zero rates in mind. This, coupled with the growth of covenant-lite loans, could lead to lower recovery rates compared with history. On a relative basis, we believe high yield therefore offers better value versus loans.
Figure 1. Prior Peaks in the High Yield Default Rate
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Source: Bloomberg and Man GLG; as of 30 November 2022. NBER recession periods shaded in grey.
Credit’s Naughty and Nice List
Christmas came early for credit this year, with strong rallies in market beta spurred by a series of encouraging economic prints. Beneath the aggregate numbers, though, the contours of the risk-on recovery revealed some decompression as lower-quality parts of the market underperformed higher-quality issuers.
We expect this to continue to be a theme in 2023, especially as cyclical sectors – which have held up relatively well in the year to date (Figure 2) – face the impact of slowing economic growth on highly operationally geared businesses. We therefore maintain our strong preference for quality companies with hard assets and strong pricing power, expressed through secured debt where possible.
Figure 2. YTD Excess High Yield Returns by Sector (Returns in Excess of Duration Matched Government Bond Curve, e.g. Contribution from Credit Spreads)
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Source: Bloomberg and ICE BofAML; as of 30 November 2022. Index used is the ICE BofAML Global High Yield Index.
Saint Nickel May Not Come Back
Stop us if this sounds familiar: a sharp spike in March and then heightened volatility ever since. But in place of the usual pre- and post-Covid analysis, this relates to the extraordinary moves in nickel futures earlier this year (Figure 3). It could be dismissed as a funny anomaly like oil futures turning negative in April 2020, but – with the metal’s price moving higher recently – it’s worth pondering the lasting implications before considering it a ‘normal’ financial asset again.
What happened earlier this year has been well reported – broadly, disruptions caused by Russia’s invasion of Ukraine sent nickel futures surging, leading to margin calls on large short positions that could not be met, so the London Metal Exchange (LME) unwound trades until prices reverted to a more normal level – so we will focus on the current state of the market.
Put simply, nickel markets still haven’t yet returned to their pre-March conditions. Bid/ ask spreads remain particularly elevated (Figure 4), even for the historically most liquid three-month contracts, while trading volumes are also a fraction of their prior levels. In our view, this is due to a combination of factors: major consumers are switching to substitutes like pig iron or ferronickel; large buyers in China are increasingly operating on the Shanghai Futures Exchange rather than the LME;3 and the LME has received legal challenges to its decision to cancel trades in March. Getting back to what was normal for nickel feels a distant prospect.
Figure 3. LME Nickel Three Month Price
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Source: Bloomberg; as of 15 December 2022.
Figure 4. Average Nickel Three Month Bid/Offer Spread
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Source: Bloomberg; as of 30 November 2022.
With contributions from: Francois Kotze (Man GLG – Portfolio Manager); Mike Scott (Man GLG – Portfolio Manager); and Amara Mulliner (Man AHL – Quant)
1. Source: Moody’s Investors Service, 21 November 2022.
2. Source: Man GLG calculations and Man DNA, Market Radar December 2022.
3. Source: Reuters, 7 December 2022.
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