Investors in high yield debt stand to benefit from the likelihood that the next recession will be driven by inflation rather than credit issues.
This should inflict far less damage on corporate earnings, believes T Rowe Price. At the same time, the firm expects high yield issuers to be better placed to withstand the coming downturn than previous ones.
“Corporate balance sheets have strengthened significantly since 2020, giving high yield issuers further protection against a recession,” said Mike Della Vedova, a global high yield portfolio manager in T Rowe Price’s fixed income division.
“The credit default cycle in 2020 was brutal, but it left the high yield sector in a much better state of health,” he added.
Broadly, T Rowe Price doesn’t foresee corporate debt defaults surging over the next year.
In particular, the inflationary nature of the current environment highlights a relatively limited concern over the creditworthiness of certain assets in comparison with downturns such as the global financial crisis (GFC) or and dot-com bust.
Historically, explained Della Vedova, damage to corporate earnings has tended to be more modest during inflation‑driven recessions.
For example, in both 1982-83 and 1973-74, S&P 500 Index profits fell by 18%. By contrast, profits fell by 49% and 25% during the GFC and dot-com crash, respectively.
The state of corporate balance sheets is also a positive sign, underpinned by robust fundamentals. In general, the strength of companies can be seen by their ability to cover short‑term obligations, with leverage ratios at low levels.
Further, the majority of high yield bond‑issuing firms have benefitted from attractive funding conditions last year to push out their maturity profiles.
“Just 1% of the debt of both US and European high yield firms will mature this year, with a relatively small amount of debt maturing in 2023,” added Della Vedova. “The bulk of the ‘maturity walls’ of high yield issuers will come in 2025 or later, indicating that balance sheets are strong.”
Another cause of optimism at T Rowe Price for the high yield market has been the recent default cycle due to Covid-19.
The year 2020 saw default rates among US high yield energy firms reach almost 30%, while debt restructurings surged among European retail firms, explained Della Vedova.
“Default cycles are useful for separating stronger firms from weaker ones, however. Those with the potential to survive and thrive beyond a crisis tend to be well supported by their sponsor investors.”
The upshot is a high yield sector in a much better state of health. Even at current market valuations, which T Rowe Price said implies a global high yield default rate of 3.9% over the next 12 months, the firm believes market valuations are only suffering from general macro concerns.