Long and Variable Lags, Event Risk, and Value in High Yield

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Welcome market participants to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about. This was the week we got to witness our lead central banker testify before Congress—that odd bit of performance art that happens twice a year. There is a lot of cryptic posturing that goes on amidst all of the give and take. It made me nostalgic for the Paul Volcker era. Back then, when Chair Volcker was asked how monetary policy could bring down inflation, he replied, “through bankruptcies.” There, clear as a bell. It really is not all that complicated.

This week, our 3 Things are:

1.???????Long and variable lags. Are markets priced for them?

2.???????Event risk. How should we view it in this environment?

3.???????High yield. Is there value at this point?

Alright, let’s dig a bit deeper.

Long and variable lags.

So, one of the things that makes this cycle so unusual is that risk premia in stocks and credit are pricing in low probabilities of recession despite the Fed’s most aggressive tightening in 40 years. So, despite the rather convincing historical record that following periods of significant central bank tightening, recessions occur, both markets’ risk premia are trading well through not only long-term averages, but well through recession norms as well.

In credit, with the upside/downside skewed toward the downside given just how tight credit spreads are, you have to wonder, what catalysts could trigger spread widening?

The downdraft in corporate earnings growth, which is now headed toward an earnings recession, has not rattled investors, in large part because those year-over-year earnings contraction percentages are forecast to be in the single digits, and only for two to three quarters. Moreover, all of that stimulus has boosted corporate margins to record levels, so in some respects, most corporates are simply giving back some of that excess profit. Taking all of that into consideration, this, in the aggregate, does not suggest a material and sustainable change to default risk.

Should investors worry more about the pace and extent of the rates rise? The answer to that is yes. Chair Powell’s testimony this week clearly drove terminal rate expectations higher, with 6% forecasts cropping up here and there. While today’s mixed jobs report has cooled those expectations a bit, the fact of the matter is the Fed is committed to dampening economic activity. And that, by definition, increases recession risk. Let’s remember what we led off with: Paul Volcker’s plain-speak.

So, if the “totality” of the data (thank you Chair Powell for our new “word of the month”) suggests the trend in inflation is stickier than expected—unacceptably high, to where the Fed has to rethink the pace and extent of its tightening—this could be that risk-off catalyst.

This really is about the Fed’s crystal ball, and what FOMC members believe about what the effects of its tightening program will look like over the next 12 months. Unfortunately for investors, the Fed has to act today. It’s a tough job, especially with market pundits coming at you from all sides. Our advice? Never lose sight of what the incentives tell you. As we have said all along, the incentive is for the Fed to overshoot rather than try to get it right, which increases the risk of an unacceptable outcome—undershooting. Think back to Paul Volcker. It feels to us, given the price of risk today, that we are skewing toward risk-off.

Alright, on to our second Thing—Event risk.

Few things strike more fear in the heart of bondholders than event risk, that out-of-the-blue change of control transaction that oftentimes results in a wealth transfer from bondholders to shareholders. The magnitude of that wealth transfer depends—to borrow from Fleetwood Mac—on what you had and what you lost. Strategic mergers, financed conservatively, usually have credit-strengthening attributes, such as scale or diversification benefits that can offset most if not all increase in financial (i.e., leveraging, risk). In its least bondholder-friendly form, a highly leveraged recapitalization, there are no strategic benefits, just increased financial risk. That investment-grade to deep junk transformation is the stuff of portfolio manager nightmares.

At the risk of stating the obvious, to make a leveraged recap work, you need buy-in from investors. And that requires some degree of certainty to pull it off. The potential buyer needs to be able to model a transaction out, to be “highly confident” in Mike Milken-speak, that debt markets will step up to fund the recap.

So, how do we think about event risk in the current environment? On one hand, credit’s new paradigm, with higher cost of capital and the higher hurdle rates that come with it, make transactions more difficult to do, all other things being equal. There is less debt available, and more costly investor expectations. Those facts stem from greater economic and market uncertainty. Uncertainty regarding one, ?the level that rates will settle out, and two, the upcoming economic impact of the fastest tightening in 40 years. Those two things at the moment present significant headwinds to potential buyers. We see the effects of that in merger and acquisition volume, which has fallen off significantly since 2021’s all-time high. That’s good for bondholders, and we would expect that downdraft to persist until we have greater visibility into the recovery.

Alright, on to our third Thing—Value in high yield.

We talked broadly about risk premia being out of step with mounting recession risk. Let’s zero in on high yield for a moment. High yield is really well bid if you consider the backdrop of near-term recession risk. Option-adjusted spreads are at 417 bps, according to the Bloomberg U.S. Corporate average, 82 bps better than its 20-year average, and well inside of the 800 bps or so level we see in recessions. Does that make sense?

The answer is a bit more complicated than saying, simply, no. Truth, of course, is a function of fundamental and technical factors. From a fundamental standpoint, the high-yield universe is in as good a shape as it has been in a decade, judging by Bloomberg’s trimmed mean debt to EBITDA calculation, which stood at 4.2x at September 30, 2022. And while the broader economic backdrop is challenging, expectations (including our own) for a mild contraction suggests that higher-quality high yield should be able to navigate successfully through.

Technically, supply expectations are down, partly because of the challenging backdrop and partly because some, if not most, of that supply has been siphoned off into more attractive (to the issuer) private credit markets. In any event, reduced supply is a plus for spreads.

We would also point out that the investment decision ultimately is driven by yields, and the spike in Treasury yields has pushed high-yield yields to levels a point above 20-year averages (8.7% today versus 7.6%) and 2 points above the post-GFC, pre-COVID average of 6.7%. So, from that perspective, high yield looks attractive.

Still, I will say, anecdotally, I haven’t found anyone excited by high yield at these levels. These levels are more normally associated with an environment where the economy is expanding and where the Fed is dovish, and neither is the case today. And the yield pickup over much safer investment-grade or even Treasurys looks skimpy. Maybe that is why short interest as a percentage of shares outstanding in HYG, iShares iBoxx High Yield Corporate Bond ETF is near its all-time high. It feels to us like the gravitational pull on high-yield spreads is wider.

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So, there you have it, 3 Things in Credit

1.???????Long and variable lags. Risk markets are not priced for them.

2.???????Event risk. Reduced visibility reduces this risk.

3.???????High yield. Gravitational pull in spreads is wider.

As always, thanks for joining us. Don’t forget to check in on KBRA.com for our latest research and ratings reports. See you next week.