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Another brick in the (maturity) wall

03 Jan 2024

  Aviva Investors

Aviva Investors: Another brick in the (maturity) wall

AUTHORS Sunita Kara,Global Co-Head of High Yield | Brent Finck, Global Co-Head of High Yield

CONTRIBUTORS Sau Mui, Pierre Ceyrac, Wes Wickens

The high-yield market is adjusting to a higher-for-longer interest rate environment, and some issuers may struggle to refinance due to rising borrowing costs. But there should be opportunities for discerning investors in 2024.

Read this article to understand:

  • The impact of higher interest rates on the high-yield market
  • Which issuers may struggle as the “maturity wall” approaches
  • Our outlook for default rates and total returns in 2024

Investors in risk assets breathed a sigh of relief as the end of 2023 approached, having almost reached the finishing line without the much-anticipated recession. Global high-yield bond investors have been able earn a strong total return that almost equalled the starting yield of the asset class at the beginning of the year.1

For 2024, our central scenario for the asset class is that:

  • Low economic growth will persist and the rate of inflation will continue to fall (albeit with prices still likely to rise faster than central bank targets). In the past, such an environment has been commensurate with “credit repair”, when companies focus on repaying liabilities. That should be broadly supportive for the high-yield asset class.
  • While we expect a more consistent economic outlook across regions and some respite from recession fears, the extended period of central-bank hiking is likely to have recession-like effects on some sectors. For example, higher borrowing costs, tighter lending standards and lower wage inflation are already having a cumulative impact on the consumer discretionary sector.
  • We are likely to see the initial stage of policy rate cuts by the European Central Bank and the Federal Reserve. However, these are not expected to have a material positive fundamental impact on financing costs and default rates, given the starting level of funding costs.

Therefore, whilst the overall macro backdrop is likely to be resilient and support global high yield, an increase in idiosyncratic risk is expected due to highly levered sectors and issuers needing to adjust to lower growth and roll refinancings into higher yields.

Refinancing in a higher-for-longer environment

Despite over a year of higher interest rates, most high-yield issuers continue to benefit from the ultra-low, fixed-rate coupons of bonds issued during 2020 and 2021.

The rate hikes delivered by central banks have only increased the cost of newly issued debt: less than ten per cent of the high-yield market has repriced during the higher-for-longer interest rate environment that has prevailed since early 2022. That has kept interest-coverage ratios well above historical levels.

However, that benefit will soon come to an end as bond maturities need to be refinanced at higher rates. To put it in perspective, the current market yield is more than two per cent higher than the average coupon rate. Credit metrics will inevitably suffer as more expensive debt replaces older, cheaper bonds and issuers’ debt-service capabilities are eroded. 

Issuance increased in 2023 as companies refinanced their capital structures. We expect this activity to accelerate further over the next couple of years as issuers are faced with a large maturity wall. That said, most of the refinancing is in BB-rated credits and we expect most of these issuers to retain market access.

The impact will be most dramatic among lower-quality issuers. The average current coupon among CCC issuers was just over seven per cent as of November 27, 2023, which was about half the market rate of around 14 per cent for this cohort.2 Such a high cost of capital will be unsustainable or unpalatable for many issuers. For this reason, we expect CCC issuers to struggle as access to the market could be limited. For those that can refinance, their interest burden will increase substantially.

We expect this to result in an uptick in liability management exercises such as “uptiering” to secured bonds (when companies issue a new senior tier of debt), equity capital injections and distressed exchanges. However, these options will not be available to many issuers. As a result, we anticipate an increase in the default rate, so credit selection will be even more critical for investors in 2024.

Figure 1: Breakeven analysis

The relationship between spread movements, changing default rates and total returns (per cent)

Relationship between spread changes and default rates

Source: Bloomberg. Data as of November 30, 2023.

Figure 2: The maturity wall (per cent)

Benchmark shown is the Bloomberg Global High Yield xCMBS xEMG 2% capped index, USD hedged.

Source: Aviva Investors, Blackrock Aladdin. Data as of September 30, 2023.

Defaults and return expectations

Despite a projected uptick in defaults, we don’t expect this to be an outsized driver of losses. We expect overall defaults to be between four per cent and 4.5 per cent in 2024, in line with the long-term average. Loss-given-defaults should remain benign, given the relatively low average price of bonds on the index (below $90), with the average price of a CCC-rated bond around $75.3

Figure 3: High-yield default rate, 1988-2023

Source: Aviva Investors, Moody’s, Barclays. Data as of September 30, 2023.

In addition, a material step-change higher in the yield to 8.5 per cent has boosted the ability of investors to earn potentially higher returns and absorb negative shocks given the cushion available from the combined spread and risk-free rate. Yields above eight per cent are relatively rare; historically, when yields have breached this level, the subsequent 12-month total return projection is positive, averaging double-digit growth.

However, while all-in yields are attractive, spreads remain close to historical averages. On fundamental reasons alone, spreads are likely to remain rangebound and unlikely to compress from here, although technical forces could exert positive pressure.

Whilst the return potential in high yield is closely correlated with the growth outlook, the higher-quality composition of the market today will likely reduce the sensitivity of spreads to downturns. Should a macroeconomic downside scenario play out, we expect spreads to widen to 600-700 basis points (bps) from the current level of 400bps. This compares to previous recessionary levels of above 800bps. At today’s yield levels, the market would have to absorb 100bps of spread widening for an investor to not earn a positive total return (see Figure 1).

It can be challenging to time the peak in valuations; therefore, allocating to global high yield at current levels may offer appealing long-term total return potential.

A shrinking market

Another development worth monitoring in 2024 is the ongoing “shrinking” of the high-yield market.

The origin of this dates back to 2020, when high yield took in a deluge of fallen angels (formerly investment-grade bonds that suffered ratings cuts to junk status), with over $172 billion from US issuers alone.4 While this improved the average rating of the market, most of this debt has since rebounded back into investment grade. In late October, carmaker Ford became the latest issuer to make the leap back into the IG indices.5

Since its peak in July 2021, the market has compressed by 18 per cent, or around $385 billion (see Figure 4).6 This leaves the global high-yield market roughly back to the size it was in the second quarter of 2015. While an uptick in issuance is expected over the coming months, much of this will be refinancing of existing debt, which will not increase the overall size of the market.

The shrinking market has brought some benefits for investors, however. The BB-rated basket now accounts for a larger weighting and CCC-rated credits a smaller share, which could be an important factor going into an economic downturn. In our view, the significant contraction in the size of the market is a supportive technical tailwind to credit spreads and bond prices, as investors ultimately have a much smaller pool of assets to invest in.

We believe this is one of the key factors that bolstered credit spreads in 2023 and reflects the resilience the market has shown during another year of uncertainty. This resilience should continue into 2024.

Figure 4: The shrinking high-yield market (par value, $bn)

Source: Aviva Investors, Bloomberg. Data as of September 30, 2023.

References

  1. Based on a 9.01 per cent total return on the Bloomberg Global High Yield xCMBS xEMG 2% capped index, USD hedged, as at November 17, 2023, compared with yield-to-worst of 9.39 per cent as at December 31, 2022. Source: Bloomberg, Aladdin.
  2. Aladdin, as at November 27, 2023.
  3. Bloomberg Global High Yield xCMBS xEMG 2% capped index, USD hedged, as of November 30, 2023.
  4. Citi Research, as at November 1, 2023.
  5. Bloomberg Global High Yield xCMBS xEM 2% issuer capped index.
  6. Aladdin Explore, as at November 1, 2023.

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