Potential opportunities await but security selection will be key
Thus, we believe there may be compelling opportunities for investors to add high-yield risk at wider spreads after the Fed begins to cut rates. (Again, though, we would advocate for more cautious positioning until then.) Further, security selection in this market will likely take on greater importance going forward. In particular, consider avoiding possible trouble spots, like issuers trying to pull off a turnaround or those overly exposed to leverage or cyclicality. We do not believe today’s uncertain environment warrants giving these types of companies the benefit of the doubt.
A high-quality market but credit spreads tend to overshoot actual default rates
High-yield credit fundamentals are starting from a position of strength, based on elevated interest coverage and relatively low leverage as of this writing, although we expect some weakening in the coming quarters as economic growth likely slows. We also anticipate that high-yield default rates may rise toward long-term averages (~4% – 5%) over the next 12 months, but we do not see a big wave of defaults on the horizon. One factor that should help limit the number of defaults is the strong quality composition of the high-yield market, less than 11% of which is CCC rated (the lowest quality tranche), compared to more than 22% just before the 2008 global financial crisis (GFC).
Speaking of the GFC, that episode was just one historical example of a period in which high-yield credit spreads spiked and overshot their “fair value” based on actual realized default rates. That could happen again, which is why we cannot necessarily rest on the current strength of high-yield market quality as assurance against sharp spread widening in the period ahead.