Commentary by Brian Kim, head of high yield research, Vanguard Fixed Income Group, and Kunal Mehta, head of fixed income specialist team, Vanguard, Europe.

 

  • There are several factors suggesting that an uptick in high-yield corporate defaults might be on the cards.
  • On the other hand, there are a number of reasons why there is no need to panic just yet about defaults.
  • A targeted, security-selection approach to active global credit is critical to mitigating downside risk in this environment.

 

Market downturns are often considered a difficult environment for high-yield bonds.

With central banks firmly in tightening mode and a number of uncertainties in the macroeconomic outlook, investors might be wondering what this means for default rates and the prospects for below-investment-grade corporate bonds.

No need to panic just yet

There are several factors suggesting that an uptick in high-yield corporate defaults might be on the cards.

Average default rates on high-yield bonds are currently very low by historical standards, at around 1%, and are well below the long-term average of 3.5%1. When you consider the impact of rising interest rates on the cost of capital for bond issuers, it is natural to expect that default rates will increase from these low levels, especially if economic headwinds intensify. For example, in June Fitch Ratings raised its 2023 US high-yield default forecast by 25 basis points to a range of 1.25%-1.75%2, reflecting in part “slowing economic growth”.

On the other hand, there are a number of reasons why there is no need to panic just yet about defaults.

For one, the quality of the high-yield universe has been steadily improving over time. BB-rated bonds (the highest-quality bonds within high-yield) have been growing as a proportion of the high-yield index, from around 35% at the advent of the global financial crisis (GFC) to over half of the index today. Over the same period, the lowest-quality CCC-rated segment has shrunk from 20% to around 10%3.

While the Bloomberg Global Aggregate Credit Index—the benchmark for the Vanguard Global Credit Bond Fund—only comprises investment-grade issues, our Global Credit Bond Fund has the flexibility to invest selectively in high-yield bonds outside the benchmark4, provided they meet our stringent requirements around risk and fundamental analysis.

High-yield universe distribution by rating

Notes: Bloomberg Global High Yield Index USD Hedged used as proxy for high-yield universe. Source: Bloomberg. Bloomberg Global High Yield Index USD Hedged distribution by rating between 1 January 1996 and 30 June 2022.

Furthermore, even if default rates do begin to rise, we have reasons to believe that they may not reach the peaks they did in previous credit cycles. One is that following the initial Covid-19 crisis in financial markets in early 2020, the credit cycle was much more truncated from its sell-off to recovery and subsequent normalisation phases than previous cycles. This was due in part to the rapid injection of liquidity that central banks provided financial markets after the world was hit by the pandemic.

As a result, there has not been as much time for the overleveraged excesses that have characterised credit crises of the past (such as the GFC and the dot-com bubble) to repeat themselves.

Another reason for this belief is that the growth of alternative credit markets5—such as bank loans and private credit—in recent years has become an increasingly important relief valve for risk in high-yield credit. As a result, there are no areas of high-yield markets, in our view, that are obviously approaching bubble territory (such as was the case with collateralised mortgage debt ahead of the GFC).

Identifying opportunities in a volatile market

After the broad sell-off that hit fixed income markets during the first half of 2022, valuations on below-investment-grade bonds became markedly more attractive, with yields now hovering around 9%6. What’s more, our credit analysis teams believe that companies on the whole are well positioned to manage any challenges in the economic environment that lie ahead. But while there are now more high-yield opportunities than six months ago, a focus on selection remains key.

Not all high-yield issuers are equally well equipped to handle financing difficulties as default rates increase. Below-investment grade corporate credit is a very diverse area of the market where fundamental and relative value analysis can help active investors to spot the best opportunities, and avoid the most perilous pitfalls. That’s why a targeted, security-selection approach to active global credit is critical to mitigating downside risk in this environment.

 

1 Source: Vanguard and Moody’s, as at 30 June 2022. Long-term average default rate based on data from 1987.

2 Source: Fitch Ratings, 14 June 2022. 2023 U.S. HY Default Forecast Raised to 1.25%-1.75% https://www.fitchratings.com/research/corporate-finance/2023-us-hy-default-forecast-raised-to-1-25-1-75-14-06-2022

3 Source: Bloomberg. Bloomberg Global High Yield Index USD Hedged distribution by rating between 1 January 1996 and 30 June 2022.

4 Source: Vanguard, as at 31 July 2022. As at 31 July 2022, the Global Credit Bond Fund had 4.94% of its assets invested in bonds rated below BBB.

5 Source: BAML, 31 August 2017 to 31 August 2022. The face value of the loan market rose from $929 billion in August 2017 to $1.425 trillion in August 2022, a compounded annual growth rate of 8.9%.

6 Source: Bloomberg. Yields for the Bloomberg Global High Yield Index USD Hedged stood at 8.98% as at 31 August 2022.

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