Seeking alpha in US high yield during economic downturns

May 19, 2023 06:00
Due to a combination of factors such as higher interest rates and reduced post-Covid office space occupancy, the commercial mortgage-backed security market has become more cautious. Photo: Reuters

The fixed income returns in Q1 show that, in an environment of elevated yields, bonds can perform well amidst a challenging backdrop. The increase in global yields to near decade-high levels indicates an opportunity to consider an actively managed bond strategy given the potential to generate alpha and total return.

While the technical backdrop of U.S. high yield bonds remains supportive due to a variety of factors including lower gross new issuance and a meaningful supply deficit, spreads are likely to widen amid slowing earnings and declining corporate outlooks. Although we remain defensive, we don’t expect defaults to be as severe as in previous downturns due to the strength of most issuers’ balance sheets and the absence of a near-term maturity wall.

Albeit not deemed as a fully-fledged one, the recent banking crisis has the potential to precipitate a deceleration in economic growth, which could adversely affect the regional banks and commercial real estate financing. The issue is that the regional banks have a significant stake in the real economy, as they are the major providers of financing for both big lenders and small to medium-sized companies, which are typically the ones employing the most people, thus potentially impacting the labor market. Those smaller banks are also responsible for a good chunk of commercial real estate financing, which is a sector that was already experiencing difficulties before the banking crisis. As such, due to a combination of factors such as higher interest rates and reduced post-Covid office space occupancy, the commercial mortgage-backed security market has become more cautious, thereby further exacerbating the challenges faced by the commercial real estate sector.

Meanwhile, investors are seeking guidance on when to assume additional risk and whether high-yield investments can serve as a viable alternative to equity allocation. While default rates have remained relatively low, they have been trending upwards. Should the economy follow our base case recession scenario, we expect defaults to remain manageable, rising to 3.5% over the next nine months and to 5% over the next 12 months. The extent to which they will be influenced by the shape of the recession and its impact on the regional banks remains to be seen.

Moreover, although valuations in high-yield markets are currently appealing, they have yet to reach the levels typically associated with recessionary periods. That said, the shrinking high-yield market due to less issuance and potential upgrades to investment grade provides a strong technical tailwind, indicating that the market is becoming more resilient. Consequently, astute investors may want to gradually allocate to high-yield while keeping a watchful eye on the situation.

In the US high yield bond markets, we see strong fundamentals in the housing sector and potential for rating upgrades for issuers who were able to generate significant free cash flow on the back of the significant housing backlog prevailing in the US since the Global Financial Crisis. Independent power producers and the gaming sector are other areas that currently we find attractive

Overall, while we are cautious in the near term as recession risk has grown. We are positioned for near-term widening but are more constructive over the longer term and looking for signals to shift to a more risk-on stance. Active management and accurate credit selection will continue to be rewarded as volatility continues.

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Portfolio Strategist at PGIM Fixed Income