November 8, 2022

Credit cross-currents:
macro uncertainty and alpha potential

Guest: Andy Toburen, CFA, Senior Portfolio Manager at Chartwell Investment Partners

In this episode of Markets in Focus

The credit market has been impacted by duration shocks, high inflation, and rising borrowing costs, leading to deteriorating credit risk. Andy Toburen, CFA, Senior Portfolio Manager at Chartwell Investment Partners, unpacks it all and shares how investors can navigate the dynamic credit markets and find areas of opportunity.

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Matt Orton:
It's been a rough year, to say the least, for investors across most asset classes, particularly in equity and fixed income. Rates have surged this year, causing multiple compressions across equities and ending the multi-decade bond bull market. The credit has been no exception. It's also been impacted by duration shocks, and now, high inflation and rising borrowing costs are leading to deteriorating credit risks. This has definitely been reflected in performance. High yield has had its worst first half on record.

Issuance has been light, investor flows into the space have been negative, and none of this sounds very good. But there's been a lot of dispersion and that creates opportunity to generate alpha, and yields are also becoming much more attractive. So, how should investors think about the cross currents of elevated macro uncertainty and the potential alpha opportunity?

This is Markets in Focus from Raymond James Investment Management. I'm your host, Matt Orton, and I invite you to join me and my colleagues as we discuss the latest trends and developments striving the markets. Visit us at for additional episodes and insights.

Here to guide us through some opportunities and risks and credit is Andy Toburen, Senior Portfolio Manager at Chartwell Investment Partners. He oversees their high yield fixed income strategies. Andy, thanks for joining us today.

Andy Toburen:
Thanks Matt. It's great to be here.

Matt Orton:
So, I want to start a little bit more generally, and Andy, perhaps you can provide some color on how both high-yield and investment-grade credit have been impacted by the sharp rise in yield, with respect not only to performance, but also new issuance.

Andy Toburen:
Thanks, Matt. Sure. For credit or corporate bonds in general, performance is driven by both changes in interest rates and changes in a bond's risk premium or its credit spread. Interest rates and credit spreads will often move in opposite directions, which can help reduce volatility in corporates, but that has certainly not been the case this year.

You mentioned a sharp rise in rates. and that's been a significant headwind on returns for both investment grade and high yield. Investment-grade instruments are typically longer duration on average than our high yield bonds, so that rate move we've seen has had a much more significant impact on the investment-grade side.

At the same time, from a credit spread standpoint, and you can think of credit spreads as a bond's incremental yield above and beyond a treasury bond. Credit spreads have also increased this year. High yield bonds are much more credit sensitive than your average investment grade bond, so the increase in credit spreads has had a more significant impact on the high-yield market. Both markets have faced steep challenges here to date and have posted similarly negative returns.

On the issuance side, or in the primary market, as you might expect, companies have not been rushing to issue new debt in the face of soft market conditions, nor frankly have investors been clamoring for new products. US investment- grade corporate issuance stands at about $700 billion year to date, which is down 10% from the comparable period at this time last year and down over 40% from 2020.

On the high-yield side, new issuance has been very meager at only about $88 billion year to date, which is down 75% from last year. High-yield issuance had been very strong in the second half of 2020 and throughout 2021 when a lot of high-yield issuers came to market and proactively addressed their near-term financing needs at that time.

Matt Orton:
Great. Well, yeah, that's definitely interesting, and so it seems like it's the willingness to come to market that's been the main drag, not just on the demand side. Maybe as a follow up then within high yield, has there been a dispersion in quality between issuers?

Andy Toburen:
Yes. Yes, there has. Higher quality high yield, and when I say that, I'm talking about namely double-B rated and single-B rated issuers have outperformed the lower quality, the triple-C rated or distressed part of the market by a few percentage points this year.

The lower quality part of high yield is much more impacted by spread widening, and these sorts of relative returns are what you would expect to see in an uncertain or softening economic environment. Of course, shorter duration has outperformed longer duration also, so higher quality and shorter duration has been the best place to be.

Matt Orton:
Gotcha. One other follow-up question to what you said before. You talked about widening credit spreads, and I think a question on the minds of a lot of investors right now is why haven't we seen credit spreads widen even more than they have in the high-yield market, given the carnage that we've seen in public equity markets? Is it not unreasonable to assume that high yield valuations would've seen the same type of destruction?

Andy Toburen:
Well, credit spreads have widened to the low 500 basis point area, or 5% more than the yield on a comparable treasury, which is about the historical average for high yield-spreads. I think part of the reason they haven't gapped out further is that the absolute level of yields and rates is so much higher than we've been used to over the past three or four years. Yields in the high-yield market are north of 9%, and typically when they reach that area, a number of investors will start to step in and allocate, because historically that tends to be an attractive entry point.

Matt Orton:
Gotcha. North of 9%, we haven't had to say that in a really long time. It's a sign of how much things have been changing this year and in such a short period of time. I think maybe what ties into that is the idea of quality that you were talking about too. We had an upgrade trend post-COVID that's definitely benefited all high yield debt, but are you starting to see this change, especially given what's happening in the markets this year? Are you starting to see downgrades pick up?

Andy Toburen:
Yes, as you mentioned, there were a lot of ratings cross currents post-COVID. One of the most impactful was that the high yield market absorbed a pretty large group of fallen angels, or investment grade bonds, that were downgraded post-COVID to below triple-B and fell into the highest quality tier of high yield.

Ironically, this downgrade trend from the investment grade market had the effect of improving average credit quality for high yield, because they did enter the high-yield market as double-Bs, or the highest quality tier within high yield. Then, of course, a strong post-COVID recovery in the economy benefited most high issuers as you alluded to.

But to your question, and more recently though, we have seen downgrades start to pick up, such that the downgrade to upgrade ratio actually moved above one during the third quarter for the first time in some time. These rating migration trends we think are something that bear watching as we move through third quarter earnings.

Matt Orton:
Similarly, high yield markets are seeing a rise in distressed debt, which tends to be a leading indicator of default experience. I hear on a daily basis from different strategists that default scenarios are way too optimistic, so I'd love to hear your thoughts on how much more default risk is to come for credit? Is this maybe only a worry say, in the triple-C part of the market, or do you have maybe broader concerns across high yield?

Andy Toburen:
Yeah, it's a really interesting question to think about what the default cycle could look like and what it will look like. So, a common definition of distressed debt would be bonds that are trading at yields of more than 1,000 basis points or 10% higher than a comparable treasury.

Today, the distressed portion of high yield is about $80 billion in value. We're roughly about 6% of the overall high-yield market, so about 6% of the overall high-yield market today trades at distressed valuations. To put that in context, just a year ago, the total value of distressed debt was less than $20 billion were only about 1% of the market, so it's definitely increased recently.

In terms of default forecasts over the next couple of years, actual default experience is going to be highly dependent on the state of the economy and US GDP growth. The forecast that I've seen calls for high-yield defaults to move from roughly 1.5% over the latest 12 months to something more like 3% to 4% in 2023. But importantly, this assumes a so-called soft landing, which I think of as sort of flat to 1% GDP growth.

If we, in fact, see a recession in 2023, even a mild recession, which I believe many are calling for, the 3% default forecast is likely to turn out to have been too optimistic. We could see the default rate move to mid- or even high- single digits in a recession scenario.

It's important to point out, though, that most bonds that may be at risk of future default will likely come from the part of the market that is already trading at distressed levels, two-thirds of which are rated triple-C or lower today. Default cycles certainly have spillover effects on trading levels of higher-quality high yield, but the risk of permanent loss of capital is typically confined to triple-Cs.

For example, in the years following the great financial crisis, consider calendar years 2008, '09 and '10. 95% of all corporate defaults came from bonds that were rated triple-C long before they defaulted. So, quality tiers within high yield behave very differently in times of stress. At this point in the cycle, we think it's imperative to have a higher quality bias.

Matt Orton:
I think that's definitely worth digging into just a little bit, because I know your area of focus tends to be in the double-B part of the market, too, so maybe you can just talk a little bit about how you evaluate opportunities in double-B, or are you seeing things migrate down from triple-B? How do you assess risks to default in the double-B space? Maybe just a little bit more color on how you look at quality.

Andy Toburen:
So, in the double-B quality tier, the high-yield space, we look at quality in a number of different ways. It primarily comes down to the consistency of a company's profit margins, the consistency of their ability to generate cash flow and service their debt, both interest and principal payments over full market cycles and during all periods, during both good markets and bad.

Matt Orton:
Well, great. Then I think that's a great transition to move on to another topic that's really important, which is the impact of earnings. That's another theme that I tend to hear in the market narrative now is that earnings need to be downgraded, earnings expectations are way too high for 2023. Earnings are important not just for equities, but also credit, because when earnings come down, credit spreads tend to widen.

So, Andy, do you anticipate seeing a significant drawdown in earnings or do you think this is contained to maybe only certain sectors or industries? And how do you look for opportunities around that?

Andy Toburen:
Yeah, I think you're onto something with the thought that we're more likely to see rolling pockets of significant earnings weakness in specific sectors of the market. The economic strength we've seen post-COVID has been very broad-based and the COVID monetary stimulus has been so large that it's hard for me to imagine significant earnings drawdowns across all sectors. I think the Federal Reserve is somewhat banking on this as they aggressively raise short-term rates and shrink the size of their balance sheet.

It's very possible that we might see a painful correction in different areas, perhaps housing or particular stress in brick-and-mortar retail, for example, or maybe commercial office real estate, or perhaps even individual commodities. To the extent this is how things play out, we'd expect to see spread widening in the sectors most affected. I think we'll continue to see localized spread volatility in this environment, and, for us, that creates a lot of opportunity.

What we've been doing for the last couple of quarters is sharpening our research focus to identify what we think are good companies with good balance sheets and creating a shopping list, if you will. Some of these have already repriced sufficiently and have made their way into the portfolio, and other names that we're looking at, we're still watching for a more opportunistic entry point.

Matt Orton:
Well, great. Thanks Andy. That's really helpful color. To dig into that shopping list with credit fundamentals generally looking healthy and the significant decline in price, I would assume that's created some attractive opportunities. So, looking forward to the rest of 2022 and maybe into next year, what parts of the market look most attractive right now?

Andy Toburen:
Yeah, the changes in the market have definitely shaken out a number of opportunities. Across fixed income, we've seen a huge shift in market dynamics due to the increase in rates that we've talked about. Over the past couple of decades, as rates were falling, high-yield portfolios tended to own bonds with what I'll call higher than market rate coupons, and these were bonds that, therefore, traded at premiums to par. In that environment, it was hard to get very excited about total return opportunities and bonds, because all you could expect in the best of circumstances was to clip your coupon.

Today, it's very different. We see a cohort of somewhat lower coupon, call it 4% or 5% or 6% coupons, high yield bonds that were issued over the last few years in a much lower rate environment, that due to the rate move this year, end up trading at substantial discounts to par, often 10- to 20-point discounts.

To me, in the big picture sense, this cohort of lower-dollar price performing bonds, and by that I mean non-fundamentally distressed, these look really interesting as opportunities for both income and potentially total return. You can still have a quality bias and a maturity profile inside of five or six years and find these opportunities.

From a sector standpoint, our largest exposures today in the portfolio are in financials and basics. In financials, we see opportunity in some names that we believe should benefit from a higher rate environment, and in basics, we see pockets of specialty manufacturing that also appear to have good pricing power.

I'll just mention another recent addition in the portfolio has been in the energy sector, with a company focused on infrastructure that we think has a long demand runway based on changing energy infrastructure needs.

Matt Orton:
No, that's very, very helpful, and it's also been a long time since we've talked about total return opportunities and in fixed income as well. I know you'd mentioned, as well some issues, maybe in areas like automotive, retail, and housing. You still think you stay away from those, because rates are going to continue to rise, those businesses are reliant on credit extension. Fundamental data maybe still looks okay for them, but it's just maybe not reflected in the Fed yet. Is that an area that investors should stay away from or do you think you can be selective there?

Andy Toburen:
We're still considering all sectors, and just maybe considering the ones you mentioned, with a little bit more scrutiny than we have in the past, given what we've seen in the economy and where we think we are in the economic cycle. Because of our quality bias, we do think that, selectively, there are opportunities in each of those sectors. We're typically looking at, as I said before, very high-quality issuers with strong balance sheets that have the wherewithal to survive different market scenarios.

Matt Orton:
Great. What about the leveraged loan market? Just because I know that's so interesting to a lot of investors. You had them take off over the past few years, but they've really, really struggled this year with concerns over economic growth, and its relatively poor-quality composition versus high yield. What are your thoughts there? Do you think this part of the market continues to underperform?

Andy Toburen:
Yeah, leveraged loans are often thought of as a sister asset class to high yield. They are an area of the market that I do have some concern about, and I do think there are some particular risks, potentially more risk in the leveraged loan market in my opinion.

Bank loans, or leveraged loans, have been the preferred financing vehicle for the majority of acquisitions and leveraged buyouts over the last decade, and that's resulted in an average quality in the bank loan space that's fallen to the mid-single-B area with upwards of 40% of the bank market rated B- or lower.

These are floating-rate debt instruments, which has been a helpful technical factor in this year's rate environment, but as time goes on, it could actually prove to be their downfall in terms of fundamental credit quality. With higher interest rates, even if you assume flat cash flows, a meaningful segment of the bank loan market is not going to be covering their new higher interest expense going forward.

In addition, many leveraged loan issuers are private, which makes access to their financial information more difficult. So, in my opinion, more so than high yield, we think the leveraged-loan market is potentially a canary in the coal mine that we're keeping an eye on for signs of stress.

Matt Orton:
Great. I think that's a perfect transition to the last question we've got time for, which is the other risks that are in the market. Outside of leveraged loans, what else do you think are the biggest risks in the high yield space moving forward?

Andy Toburen:
So, in terms of risks for high yield, the economy is always the number one, number two and number three risk as it relates to the high yield market. And we can't ignore the possibility that the Fed oversteps at some point and commits a policy error in their tightening cycle. We think about valuations in high yield in a couple of ways on a risk premium or spread basis, but also on an absolute yield basis, which we touched on a little bit earlier.

Just quick review. When we look at spreads, the market's only at about 500 to 550 basis point premium to treasuries, which is right around the long-term average and not nearly the 800 or 1,000 basis point spread that we oftentimes see in a recession. So, in that sense, I wouldn't call the narrative around high yield to be too negative at this point.

From an absolute yield perspective though, we're north of 9%, which is above high-yield's average historical yield. Today's yield level would actually rank in the 85th percentile of all yields in the last 20 years, which to me suggests two things. It suggests there's a fair amount of stress and also a fair amount of opportunity in the market.

Average credit quality in high yield has improved over the last 15 years, and we think, speaking very generally, that credit is in a pretty strong position, particularly in the higher quality tiers of the high-yield market.

Matt Orton:
Great. Well, Andy, I certainly appreciate your time today. It's been a really, really helpful discussion on an asset class that a lot of investors are looking at pretty closely. So, thank you for your time and thank you to all of our listeners for tuning in. Until next time, take care.

Thanks for listening to Markets in Focus from Raymond James Investment Management. You can find additional episodes and market insights at You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I am Matt Orton.


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