No, as the risk/reward remains uncompelling and spreads may widen further if a recession ensues. However, the sell-off has enhanced our enthusiasm for collateralized loan obligation (CLO) debt, which offers attractive pricing, solid fundamentals, and lower interest rate sensitivity than most other credit investments.
Prices for most credit assets have declined in 2022, as have prices of equities and other risk assets. The causes are well understood, with rising inflation forcing the Federal Reserve to tighten faster than expected and in turn creating concerns over the looming specter of recession. The recent repricing of credit means most assets are attractively valued relative to their histories, with US high-yield (HY) bonds offering 569 basis points (bps) of spread, around a 300-bp improvement from the miserable levels seen at the start of 2022. Leveraged loan discount margins (658 bps) have risen to a lesser extent since January, but current pricing has only been seen around 10% of the time during the last three decades.*
Despite the recent sell-off, our enthusiasm for HY bonds and loans is tempered by several dynamics. Current HY bonds and loan spreads (and yields) have historically been associated with subsequent returns in the mid-single digits, with slightly higher average returns for the latter. However, should the economy enter a recession, spreads are likely to move higher. In fact, US HY bonds and loan spreads averaged more than 900 bps during the last three recessions and peaked at more than twice this level during the depths of the 2008–09 Global Financial Crisis (GFC).
A key question for spreads is the default outlook. HY defaults spiked during earlier recessions, reaching more than 20% during the technology, media, and telecommunications (TMT) crisis, and close to that level during the GFC. Strong starting fundamentals may mean defaults are lower this time around if a recession occurs. Metrics like leverage (debt/EBITDA) are below their historical averages, and low interest rates mean HY bond (and loan) issuers have extremely elevated interest coverage ratios, and thus, cushion for expected rate hikes. Still, given the ongoing economic slowdown, most forecasters are calling for at least a gradual increase in defaults over the next 12 months, with S&P, for example, projecting the speculative-grade default rate will roughly double from 1.4% at the end of first quarter 2022 to 3% by next March.
The relative value proposition of many credit assets versus equities also does not yet look compelling. While history has shown that buying HY bonds when yields are significantly higher than the earnings yield on stocks is attractive, we are a long way away from the double-digit premiums that opened during the GFC or TMT crisis and laid the foundation for strong relative performance. Nor does relative downside risk look attractive. While equities typically fall around 30% during recessions (implying one is currently around two-thirds priced in), HY bonds would see an even larger decline if spreads rose to levels seen during previous recessions.
Credit investors should not despair, however, as the recent sell-off has enhanced what was already an attractive opportunity in CLO debt. We have recommended CLO mezzanine debt (BB-rated instruments) for some time, and current spreads at more than 900 bps mean equity-like returns are achievable even if volatility remains elevated. While a more difficult asset class to try and time, CLO equity today looks attractive in terms of the relative arbitrage (difference between asset income and liability cost). If loan prices soften in the months ahead, CLO equity also provides managers attractive reinvestment opportunities. For higher-quality fixed income buckets, investment-grade CLO liabilities look compelling. AAA paper offers near 5% yields (given current spreads of around 190 bps), and the floating-rate coupons simultaneously insulate portfolios against the Fed hiking rates more than markets expect.
We have no crystal ball, but the reasonable chance of a recession occurring in the near future means our bar for tactical bets is even higher and downside scenarios even more in focus. We have cleared this bar for assets like CLO debt, but we await a clearer signal for other assets like HY bonds.
* High-yield bond and leveraged loan spreads are as of June 30.