Key Themes for 2023: High Yield and Leveraged Loans
High Yield and Leveraged Loans
Garrett Olson, Portfolio Manager, HY Credit
Leveraged finance fundamentals look relatively resilient as we enter 2023. Per J.P. Morgan 3Q High-Yield Credit Fundaments, the leverage of U.S. high yield issuers decreased in 3Q to 3.98x—its lowest level since 4Q of 2012. Excluding pandemic recovery sectors such as Gaming/Leisure and Transportation, leverage is at a post-GFC low. This strength also shows through in interest coverage ratios reporting at an all-time high of 5.85x and in still healthy revenue and EBITDA margin trends. While our expectation is for a deterioration in fundamentals due to a slowdown in economic activity, we see ample opportunity to generate strong risk-adjusted returns by investing in resilient businesses and management teams that prioritize optionality. Similarly, we expect default rates to remain low by historical standards at around 3% on average but to tick up from an LTM rate of 1.61% for high yield and 1.59% for leveraged loans. Tight primary market conditions are likely to impact the ability of some issuers to refinance upcoming maturities, but we do not expect the impact to be widespread as market maturity walls look relatively benign following heavy refinancing activity in 2020 and 2021.
In 2022, high yield funds have seen the second largest outflow on record, while loan funds have seen modest outflows following extremely strong inflows in 2021. Our confidence around predicting flows is low, but we expect valuations in high yield on both an absolute and relative basis to be seen as more attractive than in recent years. However, concerns around economic sensitivity may dampen enthusiasm around potential allocations. Ratings trends will likely have a big impact on leveraged finance markets in 2023. While the LTM upgrade/downgrade ratio in high yield is still above 1.0 at 1.52 as of writing, November saw just 0.4 upgrades per downgrade. This is a trend we expect to continue in 2023 with weakening economic activity due to restrictive monetary policy. A ratings downgrade cycle will impact both high yield and leveraged loan markets, but we see the leveraged loan markets as particularly vulnerable. Fundamental metrics in the loan market enter 2023 in a weaker position than high yield peers, and the average rating on the loan index is lower than that of the high yield bond index. Furthermore, CLOs, which are the primary source of demand for leveraged loans, are particularly sensitive to ratings actions and could be forced sellers of downgraded loans. That said, we are also mindful of the impact fallen angel supply may have on the high yield market in 2023.
After a strong rebound in October and November, valuations on the Bloomberg U.S. Corporate High Yield Bond Index (HY Index) may be less attractive than at various points in 2022. That said, we continue to note the dispersion in yield-to-worst (YTW) versus option-adjusted spread (OAS) metrics in a historical context. On an OAS basis, the HY Index stands in the 64th percentile for the trailing one-year period and in the 68th percentile compared to the past 10 years. YTW metrics look more favorable in the 71st percentile on a one-year basis and the 94th percentile on a 10-year basis. While we believe that investors should consider both yield and spread valuations, we would note that elevated coupon income provides a tailwind that can offset the impact of dollar price declines on realized return. Combined with a historically low entry point in terms of dollar price, we believe the math behind the market may provide a favorable setup for fixed income investors in 2023.
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