High-yield debt is becoming a better investment

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The writer is a bond portfolio manager at Barksdale Investment Management and editor of the Credit Investor Handbook.

In the 1980s, when Michael Milken helped fuel appetite for higher-risk-reward corporate bonds, junk bonds became a fun asset class, with volatility and bankruptcy workouts, sharp elbows and big egos.

Credit cycle after credit cycle, if you’ve been on the right side of the distressed or subprime debt deal, you’ve accumulated pennies-on-the-dollar bonds and made big profits if they rebounded; if you were on the wrong side, you walked your holdings through the training process.

But the financial crisis led to changes in the junk or high-yield bond market that took more than a decade to play out. Increasingly, the high-yield bond category has approached general investment-grade quality.

The average distribution of securities in the Bloomberg US High Yield Index – that is, the incremental yield over Treasury rates – is a substantial 3.5 percentage points. But you’d be hard-pressed to find many individual bonds trading at that average. Instead, you’d find BB-rated bonds heading into lower-investment-grade spreads and borderline distressed loans, often with CCC credit ratings, trading at double-digit yields.

Importantly, more of the high yield universe is now made up of higher quality bonds. While issuance of BB and even high B-rated credit is robust, issuance of CCC-rated bonds has declined.

This lowest-quality end of the rating spectrum had its heyday in the run-up to the financial crisis. According to data from JPMorgan, lower-rated bonds (any bond with a CCC from at least one of the agencies) accounted for 24% of high-yield bond issuance from 2004-2007. In parallel with this trend, the syndicated loan (BSL) market came into its own as banks found insatiable demand for the loans they held on their own balance sheets.

Everyone knows what happened next: risk appetite evaporated, banks stopped making markets for the bonds and loans they underwrote, and credit investors experienced equity-like returns (in a bad way).

Issuance of lower-rated bonds subsequently declined, a trend that has accelerated recently with the era of quantitative tightening, as interest rate hikes have meant less need to search for yield. CCC-rated bonds accounted for just 6% of the past 18 months of high-yield bond issuance.

So if you’re expecting a huge wave of defaults to destroy the high-yield bond market, you might be disappointed, as the low percentage of CCC issuances over the past few years is likely to limit the suffering. While rating downgrades are inevitable in a recession, the high-yield bond market starts from a position of (credit) strength.

In the next lending cycle, private credit may bear the brunt of the defaults and distresses that used to characterize public market downturns. Highly leveraged companies haven’t stopped issuing debt in recent years; instead, they turned to private credit, which typically does not require borrowers to obtain a credit rating.

Private credit investors view their indifference to credit ratings as positive. These agencies get it wrong about ratings, but data from Moody’s shows that over long periods of time, its ratings for industrial corporate bonds are largely predictive—that is, about a third of the CCC-rated bonds in question can expect that within five years of issue versus 8% of BB.

But since private credit investors have greater access to information by virtue of being the “private party”—along with the ability to renegotiate terms on the fly that allow issuers to avoid bankruptcy and prevent losses from crystallizing at the brink of the cycle— this transition could mitigate corporate bankruptcies overall and improve the risk-adjusted return on leveraged credit.

And the “unitranche” structure used in many private credit transactions, which includes a single debt instrument in the capital structure, should increase recovery values ​​for transactions that end up in default. This is because it removes the riskiest (unsecured) part of the capital structure.

Private credit is still too small to accommodate the mega-deals that rely on the junk bond and syndicated credit markets. But it wouldn’t be a surprise to see a $25 billion leveraged buyout done entirely in the private credit market in the next few years.

The market that Milken created is in a way closed, as the qualitative aspect of the high-yield bond market looks more like investment grade, and the riskier trades return to the shadows.