Becoming more discriminatory
Increasing dispersion between the highest- and the lowest-rated segments of the US high yield (HY) market is becoming apparent. Spreads on credits rated CCC or lower have widened back to December 2018 highs, meaning that the cost of financing is becoming ever more expensive for these companies and year-to-date excess returns have dropped. This phenomenon has been driven by the deterioration in company fundamentals, with the leverage ratio increasing for the lowest-rated issuers as profits have stagnated or even fallen.
It is in this context that market participants seem to have become more selective. While gross issuance has risen overall since the beginning of the year, some of the weakest US HY companies (with negative cash flows and high indebtedness) have been finding it increasingly difficult to access the capital market.
The rise in the default rate has been particularly sharp in the energy sector, which is again going through a period of consolidation. This recalls 2015-2016, when falling oil prices led to a sharp rise in the default rate in this sector (to a peak of 22% in October 2016).
The debt level of US HY corporate issuers has continued to rise in aggregate, with BB-rated companies in particular increasing their issuance in 2019. Hence, it comes as no surprise that the US HY leverage ratio overall, even excluding energy, is rising again after two years of decline.
With spreads over US Treasuries for US HY remaining range bound overall, there are no signs of contagion from energy sector stress. Yet as we expect US economic growth to falter in the coming quarters, US HY spreads could widen. There is a risk that credit spreads rise beyond our year-end forecast of 450 bps towards 500 bps (spreads for US high yield over Treasuries stood at 440 bps on October 3). We also expect a rise in the US high-yield default rate (from 2.7% in September, but 6% in the energy sector). We therefore remain underweight US high yield in general.
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