Aegon Asset Management: High Yield Fundamentals: Weathering a Slowdown

Challenging economic conditions are setting the stage for an interesting year ahead. As the economy slows and the cycle ages, companies will likely face financial headwinds. Although firms are entering the year with solid balance sheets, can high yield issuers weather a downturn? 

Solid fundamental starting point

While caution is warranted, we think many high yield companies are well-positioned to navigate a downturn given the solid fundamental starting point. In recent years, high yield companies diligently improved their balance sheets, resulting in the lowest leverage levels in more than a decade (Exhibit 1) and the highest interest coverage ratios in recent history. This fundamental improvement is further evidenced by the ongoing upgrade momentum with rising stars outpacing fallen angels. In addition, the credit quality composition of the market has improved, with the high yield market now being over 50% BBs and roughly 10% in CCCs and below. For context, prior to the great financial crisis, the high yield market included more than 20% in CCCs and below.  

Exhibit 1: High yield companies are entering 2023 with historically low leverage


Source: BofA Global Research. As of December 31, 2022. Reflects gross and net leverage as measured by EBITDA over total debt for US high yield companies. 

Increasing fundamental pressures

Heading into 2023, the global macroeconomic environment remains extremely uncertain. Higher and potentially rising interest rates, persistent inflation, elevated geopolitical risk, tight energy markets and the effects of an uncertain reopening in China are just a few of the top-of-mind worries. These risks may well lead to further slowing of the US and developed market economies and create financial headwinds for many high yield companies. With a potential recession risk looming on the horizon, high yield companies will likely be facing slowing consumer demand and cutbacks in business investments—both of which could lead to declining revenues. Margins may contract as earnings come under pressure in the slowing economy. In addition, interest coverage ratios are likely to decline as coupon rates reset higher and interest costs increase, especially for issuers with floating rate loans. As a result, we believe fundamental improvement has peaked for many high yield companies. 

Weathering an economic slowdown

Despite the cloudy macro outlook, we believe most high yield companies are well-positioned to navigate a slowdown. Balance sheets are generally in decent shape and credit metrics are not stretched for most companies. Additionally, there is no immediate maturity wall that presents a refinancing challenge to companies (Exhibit 2) and overall liquidity levels are good. During the year ahead, we expect that the high yield market will present compelling opportunities to invest in companies with attractive risk-return characteristics.

Exhibit 2: Few near-term maturity concerns


Source: JP Morgan. Reflects the US high yield bond maturity schedule ($bn) as of November 4, 2022.


Download: AegonAM_HY_Fundamentals_Weathering_Slowdown.pdf


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