Talking heads – US high-yield bonds, where do we go from here?

This is an edited transcript of the audio recording of this Talking heads podcast

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking heads podcast. Every week, Talking heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing US high-yield bonds. I’m Daniel Morris, chief market strategist, and I’m joined by Will SprIngman, US high-yield portfolio manager. Welcome and thanks for joining me.

William Springman: Hi, Daniel. Thank you so much for having me. Excited to be here.

Daniel Morris: It’s an exciting time to be a fixed income portfolio manager. It’s been a challenging year or so, certainly a big change from the decades of a benign environment for fixed income. We know rates are going up again, there are renewed concerns about inflation and growth. And even in the short term, we’ve had a big change in perspective and sentiment. The problem seems to be that growth is too strong and that’s contributing to the inflationary pressures that we have. Which raises the question, what is the Federal Reserve going to do about it? What do you think is coming next? How do you see growth and inflation evolving this year? What will the Fed do?

William Springman: We’re all aware of the Treasury volatility. Many folks coming into 2023 were expecting much more subdued volatility, perhaps a more benign outlook, as many grasped onto the peak inflation narrative. What we’ve seen over the past few weeks has, at least to an extent, dispelled that notion. We’re in a tricky position in terms of getting a good read on the economy. You have this growing divergence between soft and hard data, soft data being leading economic indicators, purchasing manager indices, regional Fed surveys and so on. Many are flashing orange, in some cases red, which they’ve been doing for several months now. On the other hand, you’re beginning to see a pickup in the hard data, whether it’s employment related hard data or retail sales, goods orders and shipments – the corporate capex proxy – or durables, particularly durables like transportation. All this data started to pick up in earnest in January. It’s beginning to feed into this new ‘no landing’ narrative that some market participants have begun to latch on to.

I think we need to see a few more months of data for an accurate assessment of exactly what’s going on underneath the hood. The most recent data points are certainly concerning as they do point to a reacceleration not just in growth, but in inflation. That brings me to policy and how policy will respond to some of this data. Over the last few months, the Fed became more defensive in its communication with the public, largely on the back of a few weaker CPI prints showing a growing trend of disinflation. Then we had the well-choreographed rate hike step down from 75bp to 50bp to 25bp, most recently. The question now is how does the Fed respond to this data. My belief is that they want to see the next non-farm payrolls report and the next CPI print for February before deciding where to go. I think a 25bp hike is still probably what your average participant is thinking about for the next policy meeting. If this data comes in hotter than expected, 50 basis points goes back on to the table just as a potential option. You’re seeing this being baked into the market. The odds of a 50 basis point hike have grown in recent weeks. In addition to that, the terminal fed funds rate continues to increase, at least the market implied rate. It’s now somewhere around 5.5%, up from around 5% earlier this year.

Daniel Morris: Let’s turn to what that means for corporate bonds. You mentioned the wage increases that people understandably would like to get and the cost-of-living increases, which are beneficial, but that unfortunately has the effect of pushing up demand further and then we get more inflation and off we go. If we think about the high-yield market, and in particular corporate earnings, you have to look primarily at the capacity of companies to pay the payments that are due on the bonds that they’ve issued. How do you assess the health of corporate America today, or at least those companies that are issuing high-yield bonds.

William Springman: Thinking about fundamentals, we’ve had now three consecutive quarters of margin pressure across corporate America on a year-over-year basis. We’ve seen three consecutive quarters of earnings declines. But you have to think about what the starting point looked like prior to this margin degradation. Corporates were in a position of overearning and frankly, they still are. Their margins were well above mid-cycle levels. Even as they continue to come down closer to that mid-cycle area, they’re still quite high on a historical basis and this has allowed corporates to continue to maintain very strong balance sheets. Leverage has not been this low in 10-plus years and interest coverage hasn’t been this high in 15-plus years. So if you think about the starting point, it is still quite advantageous given where we are in the cycle and that obviously has direct implications for forward default expectations. Now there are particular sectors that started to weaken several quarters ago.

There is growing dispersion just in terms of corporate health. A couple of examples of this, healthcare being one. There are names in the sector in the high-yield space that are distressed. You have seen distress levels rise in that sector. Chemicals is another sector that has had issues. Others have done well, including energy, which hasn’t been on such solid footing in many years. You have to dig into the details to see what’s going on. At an aggregate level, corporate America, at least in the high-yield space, is doing quite well. Having said that, given what we’re seeing on the margin side, which is continued degradation, even if it is happening rather slowly, I do think you need to keep an eye on profit margins and free cash flow evolution over coming quarters, given that continued cost pressure, particularly on the wage side. In addition, rising rates are going to have an impact on the cash interest burden for many issuers, particularly those with a higher proportion of floating rate debt. Many of those names are in the lower ratings cohort. That could be more of a concern as we go through the next several quarters. As it stands, corporate America, from a balance sheet perspective, continues to do quite well.

Daniel Morris: So this is a tricky environment to be managing corporate bond portfolios: rising rates, strong growth, inflation, the Fed. How are you managing your portfolios and can you talk about some of the sectors that you like or the themes that you’re paying attention to?

William Springman: The best way to start is just to talk about where we are in the cycle. We are seeing a pickup in growth and inflation. We need to see how long it’s going to last. I believe it’s going to be rather short-lived. It’s hard to say whether it’s going to be several months or several quarters, but I think we are still firmly late in the cycle. Since no cycle is alike, you need to tailor the playbook for what we’re seeing at the moment. On valuations, there are obviously a number of ways to look at the high-yield space. You could look at spreads, or all-in yields. Thinking about spreads, on a historical basis, they are tight at 405 basis points. If you look back 10 years, they’re around the 50th percentile. If you look back to 2007, they’re closer to the 33rd percentile. Given my view on the cycle and the economy and policy, we’re rich here. Another way to look at it is to look at all-in yields.

Recently, deals have been moving up to around the 8.7% mark on an all-in basis. That looks better on a historical basis. Many participants were leaning into the all-in yield thesis coming into the year. The tricky thing about doing that is you need to have a good sense of where rates are going. The last few weeks have been a perfect demonstration of that. You have to think about your opportunity set. If you compare six-month risk-free paper yielding north of 5% to all-in yields in the high-yield space, the risk premium is low on a historical basis. My view is that valuations are still quite tight given where we are in the cycle, given the various risks. Spreads need to widen, not to the 800 to 1 000 basis point level that we’ve seen in past recessionary periods, but closer to fair value, which is around 500 basis points. And maybe next, if I could quickly touch on total returns, we had a negative year last year. It was the second worst year since 2008. Given the health of corporate balance sheets, given where defaults are right now, which is at a low level, and given that starting all-in yield, total returns should be okay for 2023. believe it’s going to be a sub-coupon year, but we should still eke out a positive gain.

That brings me to how to position the portfolio. We’re late cycle, but early cycle movers such as materials and retail saw quite a bit of spread widening last year and many of these sectors underperformed. So there are opportunities in some of the more cyclical sectors. We’re taking a barbell approach. We still are overweight more defensive sectors – consumer non-cyclicals, packaging. There are valuation arguments to be made for some of those sectors, packaging in particular. Some sectors that tend to be more cyclical continue to provide solid opportunities from a valuation standpoint. If you think about the credits within these sectors, they’re doing well and the growth pickup that we’re seeing should benefit them even further. Sectors such as gaming, chemicals, are attractive. Lastly, media cable has been a challenging sector. There are structural headwinds, but valuations haven’t been this wide in some time. Fundamentals, in our opinion, look okay. So we are finding opportunities within that sector as well.

Daniel Morris: Will, thank you very much for joining me.

William Springman: Thank you so much for having me, Daniel.