Three reasons why HY can withstand looming recession

by | Sep 15, 2022


By Michael Della Vedova, portfolio manager of the T. Rowe Price Global High Income Bond Fund

Recession fears are mounting as central banks continue to hike rates and issue increasingly hawkish guidance in response to surging inflation. Asset prices across the board have plummeted, particularly those of investments considered higher risk – such as high yield.

Such is the level of anxiety in markets, investors may be forgiven for wondering whether the current crisis will come to resemble the 2001 dotcom bubble or the 2008 global financial crisis (GFC).

If a recession does occur this time, the good news is it is likely to inflict far less damage on corporate earnings than in those previous downturns. Although current valuations imply corporate debt defaults will surge in 2023, we do not believe this is a realistic assessment. We see three main reasons for this:

1 – This recession will not be driven by credit

Apart from the pandemic‑induced recession in 2020, most other recent recessions have been credit‑driven. The GFC and dotcom bust, for example, were caused primarily by the build-up of debt‑related excesses in the US housing sector and internet infrastructure, respectively.

If the current downturn becomes a recession, inflation will be the main cause. Inflation‑driven recessions are rare – with the last one occurring in 1982-83. There is a risk of one now because of the colossal amount of fiscal and monetary stimulus pumped into the global economy in recent years – first following the GFC, and later during the pandemic crisis. This liquidity has inflated asset prices and driven speculation, resulting in the surging inflation we see today.

Whether a recession is credit‑driven or inflation‑driven is an important distinction to make for investors. Historically, damage to corporate earnings tended to be more modest during inflation‑driven recessions. For example, in the inflation‑driven recession of 1982-83, when the Fed hiked its policy rate to 20%, S&P 500 Index profits fell by 18%. In the 1973-74 inflation‑driven recession, when the interest rate reached 13%, profits also fell by 18%. This contrasts sharply with the GFC and dotcom crash, when profits fell by 49% and 25%, respectively.

2 – Strengthened corporate balance sheets

Corporations entered 2022 in a position of real strength, underpinned by robust fundamentals. Cash ratios reached post‑GFC highs just a few months ago, while leverage ratios were at the lowest levels since the crisis.

In addition, the vast majority of high yield bond‑issuing firms were able to benefit from attractive funding conditions last year to push out 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. The bulk of the ‘maturity walls; of high yield issuers will come in 2025 or later, indicating balance sheets are strong.

3 – We have just witnessed a default cycle

Many businesses have defaulted because of Covid. In 2020, default rates among US high yield energy firms reached almost 30%, while debt restructurings surged among European retail firms. However, default cycles are useful for separating stronger firms from the weaker. Those with the potential to survive and thrive beyond a crisis tend to be well supported by sponsor investors. Companies with little prospect of long‑term success are typically allowed to go bust.

The recent default cycle was brutal, but it left the high yield sector in a much better state of health – with the current default rates in US and European high yield at 0.36% and 0.01%, respectively. These ultralow levels are not sustainable in an environment of slowing growth and high inflation, so defaults will inevitably rise.

Indeed, current market valuations imply a global high yield default rate of 3.9% over the next 12 months. However, we believe the market valuations are being driven partly by general macroeconomic concerns and the actual default rate is likely to come in lower.

Primary markets appear in healthy state

In addition to the three factors, it is important to stress key US financial and housing markets are in much better shape than in previous recessions. Banks recently passed stress tests with ease and have solid balance sheets. Housing debt obligations as a percentage of income are much lower than in 2007-08, following hefty government payouts and elevated savings rates.

Labour markets are also generally in very good health. Baby boomers are retiring, and the immigration policies of the US and Europe mean positions are not being filled by foreign labour. This means companies are much less likely to shed staff in any future downturn. For these reasons, high yield debt is much better placed to navigate a recession than in the past.

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