As fixed income investors deal with the sticker shock of globally low interest rates, it makes sense to consider changes in the quality mix when choosing where to invest. The quality mix of U.S. high yield is at an all-time high, forward GDP projections are rising, and we expect sub-2% default rates in both 2021 and 2022. This combination paints a bullish picture for high yield credit risk, and we think it provides support for investing in the asset class at today’s yields.
It is important to consider how we have arrived at an all-time high in terms of credit-rating quality mix and default expectations. Three drivers have played central roles: record “fallen angel” volume during 2020, a lack of leveraging issuance prior to the COVID crisis, and broad-based access to capital markets, which is providing ample liquidity to issuers.
Fallen angels (names downgraded from investment grade) have historically been terrific opportunities for high yield investors, and this cycle is no exception. During 2020, fallen angels outperformed the U.S. High Yield index by about 9% (+15.02% vs. +6.07%). These names provided the high yield market with a higher mix of large-scale businesses, often without near-term maturity problems, and with an economic recovery, there is the potential that some return to investment grade ratings in the quarters ahead.
The high yield market has also benefited in recent years from reduced levels in two key drivers of ratings downgrades and default triggers: leveraging M&A and closed capital markets. The share of new issuance driven by refinancings versus leveraging LBOs remains near historical highs. In the past three years, refinancings made up nearly two-thirds of new issuance, compared to close to half in years prior. There is no doubt that this helped cap defaults and downgrades over the past year. While we expect an increase in leveraging LBOs for 2021, this does not change our default outlook as it can take several years for defaults to develop.
High yield new issuance set a record during 2020, as companies sought to bolster liquidity. For business models that were considered only temporarily disrupted, issuers could access capital and extend maturities. This liquidity kept defaults lower than prior recessions and should allow time to de-lever as the global economy reopens.
We believe it is important to dig into the details of today’s market structure when looking at yields across global fixed income. As we have outlined, we think an all-time high-quality mix and lower duration when compared to other alternatives put the high yield market in a good position to generate income for investors.