The High Yield Playbook: Positions and Possibilities

The High Yield Playbook: Positions and Possibilities

Anu Rajakumar: From the evolving composition of the high-yield market to the impact of macroeconomic factors such as tariff-induced inflation and shifting interest rates, the current credit environment is as dynamic as ever. At the same time, trends like the rising appeal of loans and CLOs, as well as increased interest in European credit, are reshaping how investors approach fixed income strategies. But how can investors navigate this complex environment to uncover value beyond investment grade? What factors are driving these trends, and how should we assess risks and opportunities in today's market?

My name is Anu Rajakumar, and joining me today is Joseph Lynch, global head of non-investment grade credit, and a senior portfolio manager for non-investment grade credit, and Rachel Young, director of non-investment grade credit research and a senior research analyst. Joe, Rachel, welcome to Disruptive Forces.

Joe: Thanks for having me, Anu.

Rachel: Great to be here.

Anu: Joe, let's start with you. The credit market has seen significant shifts recently. Why don't you tell us about the current environment as it relates to non-investment grade credit?

Joe: Sure. The biggest thing is spreads are much wider than where they were at the beginning of the year, which simply means that prices are lower and the risk premium that investors demand over treasuries is greater. That's been driven by a change in investors' outlook for growth. We came into the year expecting fairly strong growth between 2 and 2.5%. With the most recent announcements from the administration around tariffs, our growth expectation and the expectation of growth for the market has come in considerably. That's now somewhere between 0 and 1%. That's really changed the dynamics for the market, and that has started to raise the specter of much higher defaults in the non-IG market.

Anu: Great. That's a very good backdrop. Thank you very much. Those comments certainly complement the publication that your team put out quite recently. That's the quarterly fixed income outlook. In this piece, tariffs, of course, were mentioned along with the expectation for the impact on economic growth and inflation. In that piece, as you know, Joe, the team wrote, "Amid the dislocation, we are finding opportunities for careful credit selection." Joe, tell us a little bit about where you are seeing the most attractive opportunities in credit today.

Joe: There's really very interesting opportunities across all three of the major areas of non-investment grade credit. That would be high-yield bonds, bank loans, and CLO debt. It's just you need to know where to look in those specific asset classes to find value. Why we think those areas are more compelling today is the fact that spreads are much wider than where they were at the beginning of the year. You are being fairly compensated for the volatility and the fundamental risk that exists in the market. As you dig into all three of those asset classes, there's some very compelling and interesting opportunities.

For example, in high yield, the market has changed significantly over the past 10 to 20 years. We think spreads relative to the fundamentals of that market look very attractive. For investors who are thinking that interest rates may stay higher for longer, the bank loan asset class offers attractive carry today that we think is compelling. Then finally, for investors that maybe are a little bit more cautious, the CLO debt market is very interesting in our opinion. Investors can pick and choose what level of risk that they want to take, given the embedded structural protections that exist in the CLO market.

Anu: That's great. Thank you very much. I want to pick up on something that you said in that previous answer, Joe. You mentioned the high-yield market has seen a significant evolution over the past 10 to 20 years. Let's just dig into that a little bit. What are some of those key changes that you've observed?

Joe: Yes, sure. There's really three or four pretty major changes. The first is from a credit quality perspective. Double B’s as a percentage of the overall market is at an all-time high. The duration of the high-yield market is about as short as it's ever been at 3.2 years. The percentage of the market that is secured by assets of the issuers is also at an all-time high, in excess of 40%. Finally, just use of proceeds. The financings that back these transactions have been mostly used for refinancings, as opposed to historically much more for M&A or LBO activities. Just the underlying credit quality of the high yield market is much higher today than what it's been in the past. When investors think about volatility and risk, they look towards what were historical spreads in the high yield market during last bouts of volatility and crises. Investors have typically said between 500 and 600 basis points, that is a attractive entry point for high yield.

The reality is, over the last 10 years, high yield in both the US and Europe has spent very little time wide of 600 basis points.. At 500 basis points, the market has typically generated a double-digit type return over the subsequent two years. Today, given that backdrop that the high yield market is of such higher quality today, we think even inside of 500 basis points is attractive.

Anu: Absolutely. Now, Rachel, let's turn to you and let's hear a little bit more about those opportunities. From a sector-specific perspective, are there any underappreciated sectors or industries where you are seeing unique resilience, particularly amidst this tariff-related set of challenges or other headwinds in the market?

Rachel: Yes. It's a great question and one that I think is particularly interesting in this environment of global macroeconomic uncertainty and the level of risk that we might see today in the current tariff regime. It might surprise individuals to know that the overall market from a high yield and loan perspective, in our opinion, actually has relatively limited direct impact to sectors that we see in really the focus areas of tariffs. We put that in the context of closer to 10% of the high-yield and loan market. With that brings a lot of opportunities.

I think the sectors that we would emphasize, that we see some of those greatest opportunities, would be US-centric businesses.

Services sector I think is a great example of that, in which those issuers tend to be very stable businesses, low exposure to tariffs, and really have great overall durable cash flow profiles. We think the services sector is a great example. Then lastly, we also find issuers across the utility sector to be having limited impact overall to tariffs, but also on the right side of longer-term secular trends that we're seeing in terms of the energy transition across the US, the need for power generation to fuel data center growth. These businesses also have strong cash flow characteristics and benefit from overall physical asset presence that we think provides great collateral coverage.

Anu: Yes, that's great. I'm just curious if you can go a little bit more into your process as a research analyst. How do you actually go about assessing the impact of tariffs on these specific sectors that you highlighted, particularly for companies and industries that are reliant on global supply chains? How do you do that, and how do you manage some of those risks that are inherent in your investment decisions?

Rachel: Yes. It's a great question, and I think it really boils down to strong diligence at the underlying issuer level in terms of the overall exposure a company might have to tariffs. It's important to really have a strong understanding of the underlying supply chain dynamics that a company has in terms of their dependency on foreign imports, for example. We also need to make important assessments around the price elasticity of a company's products to the extent that we do find the issuer to be exposed to tariffs and the overall flexibility a company has to potentially offset those.

Interestingly, we have conducted scenario planning and analysis and stress testing issuers around these various dynamics, and we make an overall assessment in terms of their impact to their credit profiles.

Anu: Absolutely. I'm sure one of those assessments is just on defaults in general. I'm just curious, what is your current thinking on default levels in this space?

Rachel: Our team, just for some background, we conduct a bottom-up assessment of the likelihood of default across all issuers in both the loan and bond index. Importantly, as part of that assessment, we are drilling into a company's exposure to various assumptions. Our latest assumptions included a moderation and overall economic growth similar to what Joe had mentioned earlier in terms of our overall expectations there. In addition, it included this overlay of the current tariff regime.

Given the overall tariff uncertainty, we felt it was important to include that in our assessment. The outcome of that, from a base case perspective, was certainly an increase in our forecasted defaults over a two-year cumulative cycle relative to what we would have seen in the fourth quarter. However, the outcome was still one that would be a characteristic that would be similar to historical default levels from an average basis over time.

Anu: Right. Terrific. Maybe Joe, I'll turn to you now. We talked all about this moderating of economic growth and the trade uncertainty. With all that being said, European credit markets appear to have been drawing more interest from global investors. Joe, what's driving that trend, and how are you positioning to capture some of those opportunities in Europe or other areas around the world?

Joe: Sure. I think there's a couple important drivers of the change in Europe. One would be fundamentals. I think the European Union, particularly Germany, is undertaking potentially pretty significant fiscal investment, and that will drive growth throughout Europe, and we think that will be a strong positive for the region. That's a pretty significant change from what we've seen out of the region over the past decade. The other big change would be technicals. We're seeing a significant interest from investors investing in Europe. This is both European investors keeping capital in their own region, as well as other foreign investors now maybe reallocating some capital away from the US and putting that towards Europe.

I would say Asia is a area of particular interest where you might see more of those capital flows to Europe relative to the US. That's being driven obviously by a number of factors, some of which are related to tariffs and others are related to the potential growth opportunities in both of those markets. Europe has the potential for this virtuous cycle of incremental capital coming into their market, potentially driving down rates, potentially creating more demand, a positive technical backdrop, which will be good for the fundamentals of many of the issuers in that region.

I would say where we have the flexibility, we have been allocating more of our capital recently into European issuers or multinational issuers. In many of our multi-sector portfolios, we have the ability to allocate regionally, and at a high level, we believe the relative value looks much more attractive there. There's just a little bit more certainty around the growth outlook than what we're seeing in the US today.

Anu: Great. That's super helpful. Thank you very much. Now, looking ahead, what would you say are the most important takeaways for investors who are navigating the current credit environment? How should they balance these opportunities that we've been discussing today, along with the risks, to position themselves effectively in today's market? That's a question for both of you to answer.

Joe: Yes, sure. I'll take a start at it. I'd say, most importantly, our view is that a severe downside scenario is quite unlikely. The scenario we find ourselves in or the situation we find ourselves in today has really been self-inflicted, which means that it can be corrected relatively easily. Some of these tariffs and other aspects coming out of the administration can be walked back. I think a severe downside scenario of significant increase in defaults is unlikely. Our base case, again, is just a positive but very modest growth environment.

Taking that left tail risk out of the potential opportunities is really important. I think the other is just to think about the fact that our market is liquid, so we can trade around in the names and issuers, and sectors that we cover. The things that we owned six months ago, we don't own today, or as things change in the market, we can get ahead of that and won't have to deal with potential defaults and names that see significant spread widening. I think that's sometimes a underappreciated fact for these non-IG markets.

Rachel: I would add that I think what's really important in today's market is just the importance placed around bottom-up fundamental research. Fundamentally, we think there's opportunities across the landscape as we highlighted, and not only within issuers that potentially could be exposed to tariffs but really digging in and understanding where the risks lie and the opportunities that are presented ahead.

Anu: Terrific. That is great set of responses. Thank you so much for sharing those today. I can't let you go without a quick bonus question. Of course, markets have been quite chaotic in recent weeks. My question for both of you is, after a busy day of analyzing markets, what is your favorite way to unwind?

Joe: The past month, I've spent most of my time outside of work trying to analyze what the Chicago Bears are going to do with their draft picks.

Anu: Is that relaxing or more stressful?

Joe: It's actually been much more relaxing than the markets. I've been happy with the picks, now that the draft is over.

Anu: That's great. Thank you. Rachel, what about you?

Rachel: I would say my favorite way to unwind is going for a nice, long run and finishing the day with a glass of red wine. [chuckles]

Anu: How many miles are you averaging on a relaxing run?

Rachel: 3 to 5.

Anu: That is very admirable. Very good after a long day. I'm impressed. [chuckles] Thank you both for being here. In today's episode, we explored this evolving landscape of non-investment-grade credit. We talked about the impact of wider spreads, tariffs, and moderating growth across high-yield bonds. We also talked about CLOs and leveraged loans as well.

I want to just summarize again those takeaways that Joe and Rachel mentioned at the end. First of all, there was the base case that Joe mentioned positive but modest growth environment.

Second, the importance of recognizing that these are very liquid markets. Thirdly, Rachel's point about the process here in active management, which is really focused on bottoms up fundamental research, which is important for investors to remember as we're seeking to capture the opportunity set in front of us. Joe and Rachel, thank you again for joining me today.

Joe: Great. Thanks for having us.

Rachel: Thank you.

Anu: For more thoughts about fixed income, including our recent quarterly fixed income outlook, please visit nb.com/insights. If you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you'll find previous episodes as well as more information about our firm and offerings.

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