US High-Yield Outlook: 2023 poised for increased supply, though risks remain

After an inflation-stoked plunge in high-yield supply this year—from record heights in 2020 and again in 2021—Street projections for the year ahead indicate broad agreement that issuance will pick up in 2023, while remaining light by historical standards.

But the timetable for a return to normalization remains an open question, and downside risks abound.

“In terms of the Fed trying to combat inflation with rising rates, it doesn’t have a great track record in terms of sticking a soft landing,” said Scott Roth, co-head of Barings' US High Yield Investments Group.

“We do think that some level of a recession is the most probable outcome at this point,” he added, noting that it’s likely to be a light recession. “Deep recessions are usually accompanied by large imbalance in the economy, but we don’t see that in play.”

This year’s $102.28 billion of high-yield supply reflects the leanest output for the asset class since 2008’s $67.52 billion. The total is down 78% from the record-setting total of $464.50 billion in 2021, which built on $434.95 billion placed in 2020. All but two months in 2022 finalized with single-digit issuance totals, as rolling sums spiraled lower over the course of the year.

Institutional leveraged loan activity also sputtered. Loan volume was $225.05 billion for the year to Dec. 15, from a record $614.64 billion in 2021.

The average cost for high-yield bonds vaulted roughly two percentage points this year to a clearing yield of 7.35%, from an all-time annual low at 5.32% in 2021. The trend was directionally higher throughout the year, culminating in a double-digit average clearing yield for new-issue bonds in the fourth quarter.

As costs mounted, issuance skewed to shorter maturities in the latter portion of the year, as borrowers limit their running exposure to lofty interest costs.

Supply projections call for a bounce in 2023 from 2022’s low floor, but perhaps only a modest one. For high-yield, estimates range from $150 billion to $200 billion, while leveraged loan volume is forecast in the $200 billion to $300 billion range. While an improvement from 2022, those ranges still suggest among the lowest volumes in the post-Global Financial Crisis era.

“We project that high-yield issuance will remain weak next year, but improve from its abysmal pace in 2022,” noted the credit strategy team at BofA Global Research.

Prior to this year, the lowest post-GFC annual total was 2018’s $168.8 billion, according to LCD.

The team at Barclays expects the year to “get off to a slower start due to lower deal financing and the lack of opportunistic refinancing, before issuance picks up toward more normalized levels in the back half of the year.”

Additionally, J.P. Morgan’s credit research team said it expects “an increase in capital market activity for high-yield bonds and loans in 2023 amid a clearer backdrop for growth and inflation, slower pace of Fed tightening, and less rate/yield volatility year-over-year.” The firm added that “2023 should be another light year for bond and loan issuance” relative to totals over the last decade.

Barings’ Roth agrees with this sentiment, pointing to a strong technical backdrop of high cash balances and a dearth of supply. He noted, however, “an overhang” from uncertain prospects for the economy and a lack of conviction among investors. “Investors are bring pulled into this market begrudgingly,” he said.

Use of proceeds: More refinancing, less M&A/LBOs
Refinancing activity plunged in 2022, as rates swelled. Refi-driven bond issuance tumbled to $49 billion this year, from more than $290 billion in each of the previous two years. Refinancing accounted for less than half (47.8%) of 2022’s overall volume, the lowest share for the purpose since 2015, and down from annual shares of 62-68% from 2016-2021, LCD data show.

Fortunately, high levels of opportunistic issuance through the pandemic years have lowered the heat under refinancing risk. As of Nov. 30, outstanding bonds with 2023 and 2024 maturity dates totaled $40.3 billion and $74.4 billion, respectively, down from $128.4 billion and $155.2 billion outstanding at year-end 2020. Per the S&P US Issued High Yield Corporate Bond Index, the total amount outstanding as of Nov. 30 has receded to $1.6 trillion, from its peak overall total of $1.8 trillion as of Nov. 30, 2021.

“We’re down in size but having said that, most of the issuers in the market have refinanced in 2020-21,” said Mike Donelan, senior managing director and senior portfolio manager of US Total Return Fixed Income at SLC Management. “Looking forward, 2024-2025 will create challenging situations where more maturities come due. 2023 is going to present different challenges behind the backdrop of the interest rate environment and how risk assets will perform given that.”

After chipping away at bond maturities, issuers may turn their attention to near-term loan maturities.

“While opportunistic refinancing will likely be minimal, we believe issuers will look to address 2024 maturities next year and expect more bond-for-loan refinancing, given the elevated loan maturity wall and desire to lock in a fixed interest payment following the recent volatility,” stated the team at Barclays.

J.P. Morgan said it foresees “both bond and loan capital markets playing a role in the loan market’s mandatory transition to [the Secured Overnight Financing Rate] by June via bond-for-loan take-out offerings and refinancing.”

Bond-for-loan takeout volume—inclusive of pro rata and institutional loans—slumped alongside overall refinancing efforts to a slim $10.24 billion for the year to date through Dec. 8, according to LCD. For the comparable year-to-date period in 2021, overall bond-for-loan takeouts totaled $72.5 billion.

Issuers may also look to bolster general liquidity at an uncertain moment for the economy, per various Street projections. For context, LCD data show that deals backing general liquidity surged to 17% of total issuance amid the cash flow disruptions in 2020, sliding to 7% in 2021 and less than 9% in 2022.

“With elevated stress in the market, we expect more issuers to use the GCP bucket as a catch-all for broader funding needs,” Barclays strategists said.

By overall share, M&A and leveraged buyout bond issuance hit its highest mark since 2015, accounting for 35% of 2022’s issuance. However, the appetite for LBO paper waned in the latter months of the year, stalling out marketing efforts for debt financing packages for Brightspeed, Tenneco and others, and leaving bank syndicate groups holding the debt on their balance sheets.

Additionally, the shadow calendar for transactions to finance the private equity takeovers has also thinned.

“I think it would take an environment where investors are much more comfortable with the economic outlook, said Barings’ Roth. “Most companies are highly leveraged and with rates, the ability to generate to free cash flow is constrained.”

Credit strategists at Morgan Stanley noted that a return to normalization faces more than one barrier. “For activity to resume, we think a moderation in rates volatility is a necessary but insufficient condition,” they argue. “Historically, tighter policy rates and higher funding yields have not been bad for M&A activity, as these environments are also associated with healthy growth and earnings optimism. Currently, both sides of the equation—funding costs and the earnings outlook—are unfavorable. This suggests to us that, until the growth path is clear and/or rates come down, transaction activity is likely to remain sluggish.”

Credit quality: The up in-quality trade
Strategists generally agree that investors will scale back into risk from the top down, or via the crossover BBB and BB tiers for high-yield exposure. That suggests another rocky path ahead for lower-rated credits with pressing funding needs, after the back half of 2022 witnessed just a single offering with triple-C ratings, a $300 million print for Jones DesLauriers Insurance Management Group on Dec. 8.

“We recommend that high-yield investors own a barbell of BBBs and BBs for income and deep discount bonds for convexity,” Morgan Stanley said.

“We have liked the up-in-quality trade because of earnings volatility in 2023,” said Barings’ Roth. “Over the course of the last several months we’ve felt BBs were slightly rich [relative to] BBBs. Traditionally we’re high-yield buyers but have liked the BBB part of market. We don’t see a huge opportunity in BBs. We think it’s more of a duration trade in terms of rates trending lower in 2023.”

Spreads, returns and defaults: Mixed bag
The curtain closes on 2022 with the market paring some of the year’s heavy losses, as investors cautiously dip their toes in the risk pool. On a total return basis, the S&P US High Yield Corporate Bond Index carried a year-to-date loss of 9.25% through Dec. 13, which is down from a loss of nearly 15% for the first nine months of the year. The option-adjusted spread (OAS) for the index was T+405 on Dec. 13, down from a 2022 high at T+553 on July 5, and spreads in the T+500 area at the end of the third quarter. The year started with spreads at T+299.

Given the murky outlook, projections are wide-ranging on the spread front for the year ahead, from T+400 for the bulls, up to T+700 for the bears. Total return forecasts vary, from a loss of 1.5% to gains of up to 8.0%.

“Forecasts are calling for high-yield spreads to go out to 500, which is bearish,” said SLC’s Donelan. “I don’t think the most dire expectations for 700 bps will occur—I don’t see that happening in 2023.”

As for defaults, Wells Fargo portends tough times ahead.

“High-yield credit investors are charging hardly any compensation for default risks," the firm said. "That must change, and our models imply a 7% US default rate in 2023 for both high-yield and loans, ultimately reaching an 8% peak on a last-twelve-months basis in 1H24.”

Featured image by Sanja Karin Music/Shutterstock

This article originally appeared on PitchBook News