Don’t Fight the Fundamentals on US High Yield

In July, US High yield credit saw 30 upgrades totalling $33.4bn compared to only nine downgrades totalling $19.0bn. Notably, this was the lowest number of HY issuers downgraded (9) in a month since Dec 2018. Furthermore, this was the seventh consecutive month that the number of upgrades outpaced that of downgrades. Year to date, ratings agencies have upgraded 256 US HY issuers, totalling $354bn, while downgrading 111 at a value totalling just $132bn.  As a result, the ratio of upgrades relative to downgrade is greater than 2:1. 

When combined with other prevalent market dynamics, the favourable ratings trend paves the way for a highly supportive fundamental terrain as we advance through the cycle and one that is ideal for portfolio managers selecting credits. For example, the USHY default rate has declined 559bp YTD to 1.17% (0.66% Ex Energy). Moreover, it will likely rest below 1% by the end of 2021 (due to defaults from 2020 exiting the 12-month rolling calculation), and the volume of distressed bonds in USHY markets currently sits at a mere 0.18% (a low since 2011). Thus, the outlook for the asset class is compelling.

Despite these highly supportive conditions, since the beginning of July, spreads in the USHY index have widened by 40bps to 342 over the risk-free rate, as the spread of the delta variant and some judicious profit-taking caused spread expansion across the market. However, this backup in spreads and the continued improvement in fundamentals might represent an opportune entry point to add credit once again. In our view, we will see spreads compressing to the levels observed last month and beyond before this cycle peaks.