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Caution is warranted entering 2023, however volatility could present intriguing buying opportunities
Although headwinds persist, the solid fundamental starting point should help most companies weather a slowdown and result in a persistently low default rate
Spreads could widen if a recession becomes more imminent. However, elevated yields and discounted bond prices look attractive and we believe high yield could surprise to the upside and generate coupon-plus returns
Challenging economic conditions are setting the stage for an interesting year ahead in the high yield market. As the economy slows and the cycle matures, we believe caution is warranted. However, we expect dislocations to expose intriguing buying opportunities and attractive entry points.
Healthy fundamental starting point
From a fundamental perspective, most high yield companies are entering 2023 in a healthy state. Companies have diligently improved their balance sheets, resulting in low leverage ratios (Exhibit 1) and high interest coverage.
Exhibit 1: Low leverage and healthy fundamentals entering 2023
Source: BofA Research as of September 2022. Reflects Gross and net leverage for US high yield companies (as tracked by BofA).
Although corporate earnings were resilient amid rampant inflation in 2022, we believe fundamental improvement has peaked and margins may contract into next year. This could erode credit metrics, especially for the companies that are more levered and reliant on growth. That said, given many issuers are starting in solid financial condition, we believe most high yield companies can weather an economic slowdown. In addition, while the outlook is cloudy, slowing economic growth can bring relief for high yield companies as inflationary cost pressures fade and companies gain more clarity on the economic path forward.
Muted default outlook
As recession odds increase, investors typically grow concerned about defaults. While defaults trend upward during recessions, we expect defaults in the next downturn to be more muted. This view is based on various factors including the healthy fundamental starting point, a higher-quality high yield market, and few near-term maturity concerns.
First, the strong fundamental starting point should help limit distress and defaults compared to prior downturns. Second, the current high yield market has the highest credit quality composition in decades with low levels of CCCs and below, and a higher percentage of BBs. Notably, the high yield market has been cleansed of the more challenged credits during the various downturns or crises in recent years, such as the global pandemic and the 2015-2016 energy situation. In addition, most high yield companies have very few near-term maturities, which reduces refinancing risk (Exhibit 2). And discounted bond prices should help limit the actual loss in the event of default.
Although headwinds will likely persist in 2023 and defaults are expected to increase off current lows, we anticipate more subdued default rates during the next recession relative to prior downturns.
Exhibit 2: Few near-term maturity concerns support a muted default outlook
Source: JP Morgan. US high yield bond maturity schedule ($bn) as of November 4, 2022.
Compelling entry points ahead
After many years of low rates, the high yield market currently offers high all-in yields potentially above 8%.1 Although each cycle is different, and the current yield is primarily the result of higher rates, yields above 8% have been relatively rare and have historically provided attractive long-term return potential. Additionally, bond prices that are well below par should also provide positive convexity and price appreciation potential.
Prior to 2022, there have only been eight months during the last 10 years that offered a starting yield above 8% (Exhibit 3). Historically, investing when yields were above 8% resulted in roughly 8% to10% average annualized returns over a one-, three- and five-year basis (Exhibit 4). Extending this analysis back to the financial crisis in 2008, there were more periods with yields above 8% amid the global financial crisis. While these environments were fraught with economic weakness and macro headwinds, the high yield market generated strong rallies that provided opportunities for investors to generate above-average forward returns. Since 2008, the average forward returns ranged from about 11% to 18% over a one-, three- and five-year basis for the Bloomberg US High Yield index.1
Exhibit 3: Starting yields above 8% have been relatively rare1
Past performance is not indicative of future results. Source: Aegon AM and Bloomberg. Based on month-end Bloomberg US Corporate High Yield Index data from January 31, 2008 – September 30, 2022. Reflects the forward annualized returns for periods when investing at yields above 8%.
Exhibit 4: Yields above 8% have historically provided compelling entry points and above-average forward returns1
Average forward returns from starting yields above 8%
Annualized index returns (Sept 2012 – Sept 2022)
Annualized index returns (Jan 2008 – Sept 2022)
One-year return
18.04%
18.60%
Three-year return
8.38%
13.46%
Five-year return
8.18%
11.16%
Past performance is not indicative of future results. Source: Aegon AM and Bloomberg. Based on month-end Bloomberg US Corporate High Yield Index data from January 31, 2008 – September 30, 2022. Reflects the forward annualized returns for periods when investing at yields above 8%.
While high yields and low bond prices are attractive, current high yield spreads are around historical averages. With spreads below 600 basis points, spreads are not yet reflective of an imminent recession. Given the elevated expectations for a recession in 2023, it is likely that the high yield market could be biased toward bouts of spread widening in 2023.
If the recession is relatively short and shallow, elevated spreads could prove short-lived and be followed by a sharp snapback. These environments have historically created compelling entry points and provided outsized forward returns for investors with a longer time horizon. While there are risks ahead, we think high yield bonds will provide solid relative value versus many other asset classes. Absent a prolonged and deep recession, we maintain a positive outlook on high yield valuations and expect high yield could generate coupon-like or coupon-plus returns in 2023.
Uncovering opportunities amid uncertainty
Volatility will likely remain elevated in 2023 as the high yield market grapples with macro headwinds. Navigating market uncertainty in the year ahead will require a sharp focus on balancing risk and reward. Idiosyncratic situations are likely to continue to create dispersion and credit problems, requiring an ongoing emphasis on rigorous bottom-up research and credit selection. Similar to 2022, avoidance of credit problems and mitigating downside risk will likely be key return drivers.
As the year unfolds, we expect opportunities will arise to add risk and to capitalize on dislocations. In this environment, we remain cautious and ready to take advantage of dislocations to lock in higher yields. In 2023, we believe it will be essential to balance patience and discipline with an ability to aggressively pursue potential once-in-a-cycle opportunities.
1All investments contain risk and may lose value. Indices do not reflect the performance of an actual investment. It is not possible to invest directly in an index, which also does not take into account trading commissions and costs.
Unless otherwise noted, the information in this document has been derived from sources believed to be accurate at the time of publication.
This material is provided by Aegon Asset Management (Aegon AM) as general information and is intended exclusively for institutional and wholesale investors, as well as professional clients (as defined by local laws and regulation) and other Aegon AM stakeholders.
This document is for informational purposes only in connection with the marketing and advertising of products and services, and is not investment research, advice or a recommendation. It shall not constitute an offer to sell or the solicitation to buy any investment nor shall any offer of products or services be made to any person in any jurisdiction where unlawful or unauthorized. Any opinions, estimates, or forecasts expressed are the current views of the author(s) at the time of publication and are subject to change without notice. The research taken into account in this document may or may not have been used for or be consistent with all Aegon AM investment strategies. References to securities, asset classes and financial markets are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions. It has not been prepared in accordance with any legal requirements designed to promote the independence of investment research, and may have been acted upon by Aegon AM and Aegon AM staff for their own purposes.
The information contained in this material does not take into account any investor's investment objectives, particular needs, or financial situation. It should not be considered a comprehensive statement on any matter and should not be relied upon as such. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to any particular investor. Reliance upon information in this material is at the sole discretion of the recipient. Investors should consult their investment professional prior to making an investment decision. Aegon Asset Management is under no obligation, expressed or implied, to update the information contained herein. Neither Aegon Asset Management nor any of its affiliated entities are undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable US federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.
Past performance is not a guide to future performance. All investments contain risk and may lose value. This document contains "forward-looking statements" which are based on Aegon AM's beliefs, as well as on a number of assumptions concerning future events, based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance, and actual outcomes and returns may differ materially from statements set forth herein.
Investments in high yield bonds may be subject to greater volatility than fixed income alternatives, including loss of principal and interest, as a result of the higher likelihood of default. The value of these securities may also decline when interest rates increase.
The following Aegon affiliates are collectively referred to herein as Aegon Asset Management: Aegon USA Investment Management, LLC (Aegon AM US), Aegon USA Realty Advisors, LLC (Aegon RA), Aegon Asset Management UK plc (Aegon AM UK), and Aegon Investment Management B.V. (Aegon AM NL).Each of these Aegon Asset Management entities is a wholly owned subsidiary of Aegon N.V. In addition, Aegon Private Fund Management (Shanghai) Co., a partially owned affiliate, may also conduct certain business activities under the Aegon Asset Management brand.
Aegon AM UK is authorised and regulated by the Financial Conduct Authority (FRN: 144267) and is additionally a registered investment adviser with the United States (US) Securities and Exchange Commission (SEC). Aegon AM US and Aegon RA are both US SEC registered investment advisers.
Mark Benbow, portfolio manager, is a member of the global leveraged finance team. He specialises in high yield bonds and co-manages our global high yield strategies.