The euro and USD high-yield and senior secured loan indices performed well in 2023, and their yields are currently well above the 10-year average. Sven Kreitmair, Portfolio Manager Credit, and Pieter Rommens, Head of Senior Secured Loans, examine the credit market environment and expect good returns on leveraged finance investments in 2024 too.

Due to falling interest rates and credit risk premiums (spreads), high-yield bonds (HY) and Senior secured loans (SSL) in euro and USD generated a total return of more than 10% in 2023. The return was significantly higher than originally expected as the credit market environment continued to be shaped by cost inflation, slow growth, higher financing interest rates, stricter lending standards of banks and rising default rates.

Credit risk premiums for high-yield bonds declined by up to 130 basis points (1.3%) in 2023, after reaching almost 500 basis points (5%) at the beginning of the year. There were two main reasons for the major spread volatilities over the past year: In the first half of the year, it was headlines about regional US banking sector failures that increased uncertainty and pushed spreads up to 1.5%; in the second half, it was concerns about prolonged inflation and higher interest rates that drove spreads up to 0.8%.

Rising default rates, but BBs with lowest risk

Shortly after the start of the Russo-Ukrainian war, but also triggered by the increase in interest rates, default rates increased in sub-investment grade, in Europe since February 2022, in the US since April 2022. According to Moody’s, they currently stand at 3.6% in Europe and 5.5% in the US. This is above the average of the past two decades of 3.2% and 3.9%, respectively. For 2024, the rating agency’s baseline forecast assumes a further increase in the default rate before the subsequent expected peak and decline.

However, over the one-year investment horizon, average global default rates for BB issuers are only around 1%, while they are significantly higher for lower credit qualities (around 3% for Bs and 9% for CCCs). In addition, the potential loss in a default scenario is reduced by the so-called proceeds of realisation, which in the long term averages about 40% for bonds and 60% for SSL. However, depending on the stage of the default cycle and whether a bond is secured or unsecured, these proceeds can vary widely.

Sven Kreitmair
The continuing high return, but also a clear focus on credit selection, are the decisive factors for good performance in this asset class in 2024.

Technical and fundamental factors are positive for high-yield bonds

Swiss Life Asset Managers believes that several technical and fundamental factors speak in favour of investing in high-yield and credit funds and make them less risky than at first glance. The continuing high return, but also a clear focus on credit selection, are the decisive factors for good performance in this asset class in 2024.

  1. BB share: The share of BB issuers remains high and close to its 10-year average. The share of BB loans that – as mentioned above – have a comparatively lower default rate is currently 70% for HY in euro and almost 50% for HY in USD. In the case of senior secured loans, the share of BB issuers has fallen below 40%. Nevertheless, in absolute terms, the higher-quality BB segment has increased along with the strong growth of the asset class.
  2. Size of index and net issuance: The index for high-yield bonds and senior secured loans has contracted since its record high in 2022. For credit spreads this is quite positive. There are two main reasons for the “shrinkage”. On the one hand, several rising stars, i.e. issuers upgraded to investment grade, have left the HY index. On the other hand, net sales1 of high-yield bonds and SSL declined in 2022/23 after the record issuance in 2020/21. Despite the still-high interest rates and lower demand for acquisition financing (M&A), issuance is expected to increase in 2024 to refinance 2025 maturities. While this is likely to lead to some volatility in spreads, the level of net issuance should be more in line with previous years’ average and therefore sustainable for the market. It also creates attractive investment opportunities, as refinancing issues are associated with a corresponding premium. We also expect new names to enter the high-yield market. This should provide a degree of diversification.
  3. Distressed debt: These are HY bonds from issuers where at least one bond has a credit spread of more than 1000 basis points (similar to an SSL traded below 80 ct per dollar). This proportion of high-yield bond issuers is currently 9% (USA) and 10% (Europe). A large part of the credit risk in the weakest rating segments is thus already priced into the spreads.
  4. Record-low duration: The duration of the HY indices in euro is 2.7 years, the lowest in ten years; the duration of the HY indices in USD is 3.3 years, well below the ten-year average of 4.1 and 4.5, respectively. This low duration level reduces the impact of spread and rates volatility on the 2024 performance.
  5. Credit metrics: The key credit figures of issuers of high-yield bonds remain fairly adequate. Although revenue and EBITDA growth rates have declined since the second quarter of 2002 and net debt or interest coverage have weakened in recent quarters, they are still above their long-term averages.2
Pieter Rommens
The variable-rate senior secured loans are still benefiting from a high interest rate environment and will again post attractive returns in 2024.

Positive overall return prospects for high-yield bonds and senior secured loans

Despite the strong performance over the past year, the current returns of high-yield bonds denominated in euro (6.3%) and USD (7.7%) as well as SSL denominated in euro (8.0%) and USD (8.7%) are still 1–2% (HY) and 3% (SSL) above their 10-year average, respectively. Given these persistently high yields at record low duration levels, we expect another good performance for high-yield bonds in 2024. The variable-rate senior secured loans are still benefiting from a high interest rate environment and will again post attractive returns in 2024.

BBs in euro still preferred

In view of the increased uncertainties on the credit market, the elevated interest rate volatility and a presumably further increase in default rates and credit spreads, at least for a few months, we continue to favour the comparatively secure BB segment for both high-yield bonds and senior secured loans, namely in euro. The current yield of BBs for both HY bonds and SSL is at a high 5–6% in both USD and euros. Nevertheless, we favour euro BBs as their credit risk premium (vs. government bonds) for HY bonds is around 0.7% higher than that of USD BBs. In addition, the credit risk premium of BBs in euro – as opposed to BBs in USD – is currently only 0,3% lower than its 10-year average. In addition, hybrid bonds issued by investment-grade-rated companies, which we consider to be solid components of high-yield portfolios, account for almost 30% of the BB index in euro.

1 I.e. gross sales minus maturing, tendered and cancelled bonds
2 Source: J. P. Morgan Data, excluding financial and utilities

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