High-yield market tanks in September

Private credit vulnerable to return of delayed default cycle

In September, the high-yield market had its worst month since February, and if it wasn’t for a strong close to the month, it would have had its worst month of 2023. The market generated a return of -1.2% with Option Adjusted Spread (OAS) widening by 18 basis points (bp) to finish the month at 403 bp. The primary driver of returns in the month was higher interest rates, as 2024 rate cuts are being priced out in favour of a “higher for longer” for reality. While spreads are not historically cheap, the yield to worst for the high yield market hit the highest level of the year in early October, above 9%.

The spike in government bond yields since the U.S. Treasury issued its Quarterly Refunding Announcement on July 31 has been the primary driver of most financial asset prices over the past two months. When there is strong momentum for assets in either direction, there can be calls made by market participants who might overly emphasize recent developments.

We watched Jamie Dimon’s annual keynote address at the JP Morgan Leveraged Finance conference in early 2021, where he argued that interest rates would rise in the years ahead, and this was a much larger risk than spreads as corporate fundamentals were solid. While that was certainly a great call, and far from consensus at the time, we believe that his recent prediction that we will see 7% interest rates is significantly less likely.

Our basis for this thinking is that ultimately something will break well before rates reach those levels. We believe that extending duration looks attractive on a tactical basis at least, as long-term interest rates have seen a big move in just over two months, tightening financial conditions significantly.

High yield spreads had only approached their long-term average as of the first week of October in the mid-400s on an Option Adjusted Spread (OAS) basis vs. government bonds. However, the all-in yield of about 9.3% is quickly approaching last year’s peak of 9.6% and peaks of the 2011 and 2016 market selloffs when yields peaked at around 10%.

While we have historically focused mostly on spreads, we believe that all-in yields are now too high to ignore from a positioning perspective. Even if the market sells off further from here with a duration of just 3.7 years, we believe that the high-yield market has a good chance of delivering equity-like returns in the years ahead. This is especially true given that-large cap equity multiples remain elevated, arguing that fixed income appears to be relatively attractive on a cross-asset basis.

Another key development in leveraged finance markets over the past several years is the increasing role of private credit, which has grown from less than $300 billion in 2010 to nearly $1.5 trillion in 2023. In contrast, the high-yield market has a market value of $1.2 trillion, which is about the same as it was 10 years ago. While some good-quality issuers make up a portion of the private credit market, we believe that many of the smaller, more economically-sensitive issuers who might have traditionally come to the high yield market chose instead to access private debt markets.

This is particularly true for private equity issuers, as LBOs have increasingly turned to private credit instead of broadly syndicated loans, peaking as high as a 98% share for private credit in the fourth quarter of 2022. While high historical returns have attracted a lot of capital to private credit, we believe that the market has yet to face a true cycle as the extraordinary intervention from central banks and governments short-circuited the default cycle in 2020.

It will be interesting to see how the market fares in the years ahead, but we suspect that not every firm was as careful as they should have been when underwriting transactions during the boom times.

We believe that the combination of significantly higher base rates and an issuer base that is more skewed toward publicly listed entities argues that a spread blowout might be significantly less severe than in past credit cycles. We had previously thought that spreads might peak at 700-900 bp, but in light of base rates moving higher, we think that 600-800 bp might be closer to the mark in a recessionary environment. In each of the past three recessions, high yield spreads have hit at least 1,000 bp.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Fund Manager’s Commentary, September 2023. Used with permission.

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