There had been two main causes of the high yield market’s troubles since central banks began raising interest rates to fight inflation in 2022. First, investors could secure yield elsewhere without taking undue credit risk, reducing demand for high yield bonds and related exchange-traded funds. Second, recession worries caused investors to shun weaker credits. This made borrowing expensive for below-investment-grade issuers, especially those that needed to refinance the outstanding debt that they issued in the low-rate, pre-2022 environment.
But the markets rallied late in the year after expectations of a U.S. Federal Reserve pivot toward looser monetary policy grew in November and were confirmed by the FOMC’s December meeting announcement. The Fed essentially said that no further rate hikes were imminent, and that it expected to begin cutting rates in 2024.
Global High Yield Issuance Rebounded in 2023
Even before what the market calls the FOMC pivot, issuance in the U.S. and Western Europe was strong. The regions posted double-digit increases in the first nine months of 2023 over the same period in 2022.
U.S. high yield issuance was $118.6 billion in the first nine months, up 41.3% over the year-earlier period, according to Debtwire and White and Case. Issuance in Western and Southern Europe grew 38.7% to $62.2 billion.
In the Asia Pacific region, excluding Japan, issuance fell as Chinese real estate project financings dropped off sharply due to problems in that sector. The region’s high yield issuance fell by 68.9% to about $7 billion in the first three quarters of the year.
Refinancing drives issuance
The strong year-on-year performance of the U.S. high yield market was underpinned by robust refinancing activity. White and Case data show that there were $74.8 billion worth of refinancings in the first three quarters of 2023, up 143% year-over-year.
That is a relief for those worried about the looming “wall of refinancings” – the large amount of debt that needs to be refinanced starting in 2024. In June of 2023, the average maturity of outstanding junk bonds was only 5.2 years, the shortest on record. The robust refinancing activity in the second half of the year will have extended that average maturity, reducing worries that borrowers could be locked out of the market when their bonds come due.
Even so, refinancing in 2023 did not come cheap. Average yields on secured high yield bonds was just over 9% in the third quarter, up from 8.6% in the first, while unsecured bonds’ average yield was 8.9%, up from 7.8% in the first quarter of 2023.
U.S. High Yield Returns Benefitted from Risk-On Attitude Since November
Investors found attractive returns in the high yield market in 2023. The S&P U.S. High Yield Corporate Bond Index ended the year with a 13% return, most of which was accumulated in the last two months of the year. The 2023 return is versus an 11.2% decline in 2022, according to several publications.
Meanwhile, in the leveraged loan market, high yield senior loans were on track for a 2023 full-year performance of 13.2%, the second-best on record after 2009, according to Nuveen.
S&P U.S. High Yield Corporate Bond Index
Source: S&P Global
Flows into the High Yield Bond Market turned Sharply Positive in November, Erasing Earlier Losses
According to Morningstar, high-yield bond funds absorbed $13 billion in November, in their best month since May 2020: Morningstar Bond Flows
European Recession Worries Cause the Yields on the Weakest Credits to Diverge from U.S. Levels
Despite this positive news, the outlook diverged depending on the home of the issuer. For the riskiest corporate issuers, those rated triple-C and below, Europeans had to pay a spread of over 18 percentage points. That compares with a spread of only about 9 percentage points for U.S. issuers with the same credit rating, according to the Financial Times.
The difference between the two regions’ credit spreads was the widest since the Great Recession in 2008-09. Source: FT.com
The FT noted that this divergence was seen only among the weakest credits, tracked by the ICE BoA Indices for issuers rated CCC and below. Broader high yield indices that include stronger credits had spreads that were much closer in size; in one example, only about a half a percentage point apart.
That led observers to conclude that the tighter spreads for the lowest-rated U.S. companies, compared with the wider ones in Europe, reflects both the strength of the U.S. economy, and the possibility of a recession in Europe.
High Yield ETFs saw the largest inflows on record during the November-December Risk-On Sentiment.
The recovery in high yield bond demand came in large part from a booming business in exchange traded funds. In November along, high yield ETFs saw inflows of $11.6 billion globally, including $10.8 billion in U.S. products, according to BlackRock. This overshadowed the earlier record of $8.6 billion in April 2020, when the junk markets were unexpectedly booming in the period after the pandemic lockdowns. It also offset the total outflows seen between August and October.
Fee Competition among BlackRock, Schwab, and State Street Could Benefit ETF Inflows
A price war in the high yield ETF market flared up in 2023 and might be contributing to their popularity. In July, Charles Schwab entered the market with an ETF priced at the same level as the market’s cheapest, offered by State Street at 10 basis points. This undercut BlackRock’s flagship junk bond ETF, which charged 22 basis points.
State Street responded to Schwab by slashing its fee in half, prompting Schwab to cut its fee to 3 basis points. In the end, BlackRock cut its fee to 8 basis points in response. This is having the desired effect. BlackRock’s ETF may have lost $277 in flows in the year to October 31, but it gained $226 million in flows for the quarter ending October 31.
Following trends for junk-rated issuers in 2024
Given the potential for central bank rate cuts in 2024, and the refinancing business that was able to be completed in 2023, the immediate urgency for issuers to tap the market preemptively is receding. In fact, spreads on high yield bonds might contract in 2024 if demand from ETFs continues to build, and the returns on safe cash-like investments such as bank savings accounts and money funds fall as interest rates come down.
Waiting to issue means risking headwinds from a recession, especially in Europe, or more sustained inflation and therefore fewer-than-expected rate cuts. Nonetheless, high yield issuers following such developments might want to wait to see if they can issue more cheaply later in the coming year.
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