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High yield issuers most exposed to a slowdown

04 October 2019

5 minute read

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

Despite concerns over high leverage levels and an economic slowdown, the outlook for investment grade debt looks attractive. However, security selection will be key for speculative grade debt late in the cycle as the risk of a slowdown and a surge in default risk rises.

Record investment grade debt issuance

Investment grade debt issuance of $160bn in September was one of the largest on record as issuers took advantage of ultra-low yields across the curve. Although spreads have widened on the back of lower growth and political risk, investors are still attracted to the asset class.

The average subscription per deal during September was more than three-times higher than the respective issue size. Furthermore, issuers only had to pay a minimal premium (concession), compared with bonds trading in the secondary market, in order to attract new investors.

Attractions of investment grade

While the continued growth in the debt universe raises concerns about increasing leverage levels, investment grade bonds still appear attractive for two reasons:

Firstly, spreads in our view compensate investors adequately for the respective leverage. While the spread for investment grade issuers in relation to leverage is at its 15-year average, high yield bond spreads trade well below their long-term average (see chart).

Secondly, fears of default rates for investment grade issuers surging substantially seem overdone, given that the rate remained relatively low even during the 2008 credit crisis (see our September issue of Market Perspectives).

Investment grade spreads more attractive

Speculative debt spreads do not compensate for inherent risk

The high yield and leveraged loan market, which are the home for speculative-grade issuers (BB+/Ba1 or below), have performed well most recently on the back of renewed inflows. US high yield spreads are roughly 50 basis points (bps) away from levels last seen in 2018, 2014 and back in 2007. We believe that investors, by contrast to investment grade bonds, are not sufficiently paid given the decreasing quality in that segment and the deteriorating growth prospects.

Lower issuer quality suggests higher default risk

While default rates at this point are at record lows, supported by amplified liquidity and solid earnings, it is the high yield and leveraged loan segment which is most exposed to default and downgrade risk in a late cycle.

Although we do not believe that a recession is imminent, it is likely that growth and margin pressures will mount and, in turn, will particularly expose the lower end of the credit quality segment.

The rise in leverage within non-financial corporates and the decreasing level of protection investors receive through weaker covenants in bond and loan documentations, suggests that the next default cycle could be more severe than previous cycles. This risk is amplified by the increase of lower quality rated issuers within the segment not at least spurred by the increase of new entrants which are rated CCC/Caa or lower.

Weaker credit metrics

The median leverage ratio (debt/equity) for US high yield issuers has grown significantly in recent years and stands at 4.25 times which is close to previous cycle highs. While the median interest coverage (operating earnings available to serve interest expenses) among high yield issuers has fallen only slightly, interest coverage in the loan sector is at its lowest level since 2015.

Maintaining a high degree of leverage may well work in a growth environment but bears risk when earnings margins and growth decline. While margins in the US loan sector seem stable, growth in the three months to June, on a year on year basis, declined from 9% to 5.5%.

The increasing risk within the speculative grade segment is underpinned by the proportion of issuers with a low credit rating. The cohort of B3 or lower rated companies (as rated by Moody’s) makes up 29% of the non-investment grade population, almost double the15% share seen just before the 2008 credit crisis. Within the loan market, the proportion is even higher at 40%, compared with only 13% in 2008. As per previous default cycles, prior spikes of B3-listed issuers or lower usually preceded default rate peaks.

More defensive solid credits will be less exposed to defaults

Following the 2008 credit crisis, default rates, including investment grade and speculative grades, rose to 2.9% at their peak from nearly 0% in the previous year. By comparison, default rates of speculative grade issuers in isolation peaked in 2010 at 14.3% from the long-term average of 4.4%.

The increase in leverage combined with a deteriorating outlook for growth, as suggested by weakening purchasing managers' indexes, increases the risk that defaults and downgrades could be on the rise again (see chart).

Given the higher leverage and the lower quality (high proportion of low-rated bonds) within the speculative grade segment, the cycle has the potential to be more severe than in previous cycles. More solid credits which are less exposed to cyclicality will likely be protected in a downturn on the other hand. Selection therefore is key.

Link between weaker putput and more issuer downgrades
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Market Perspectives October 2019

Barclays Private Bank investment experts highlight our key investment themes. They show how security selection and a bias to quality companies can provide the yield and outperformance needed at a time when it may be tougher to produce positive returns.

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