Fundamentals and technicals combine
2023 finished with an exceptionally strong rally, capping the second best year ever for loans and eighth best for high yield. While a favorable equity backdrop and declining Treasury rates certainly helped, we’ve been commenting on the positive underlying fundamentals and technicals across credit markets for the entire year. Attractive yields and what we believed to be fairly valued spreads finally combined with positive market sentiment to reward patient credit investors, especially in high yield.
The downside is that some of 2024’s return potential was likely pulled into 2023. As of mid-November, some analysts were calling for 2024 returns of as much as 11% for high yield and 9% for loans, views with which we agreed. However, with credit yields still hovering around 7.75% for high yield and 8.75% for loans, we believe credit markets remain attractive. In a soft-landing scenario like that underpinning the equity market today, high yield could continue to generate a total return in excess of its yield. If sentiment changes and markets broadly move lower, or fears of a recession start to grow, we believe credit also remains well positioned against an expensive equity market. Spreads could widen by 300bps–400bps, a large move by most measures, and credit returns could stay flat to slightly positive while equities experience double-digit declines.
Credit fundamentals and technicals remain largely supportive, as companies have been relatively conservative in managing their balance sheets over the past two years. We believe this will continue as companies remain focused on addressing nearer-term maturities rather than new, incremental borrowings. This has the added benefit of supporting what has been two straight years of favorable supply/demand dynamics in both high yield and loans. We are monitoring a growing dichotomy in quality between the high yield and loan markets and a further diversion between public and private loan issuers. Default rates are likely to stay around current levels in our view, but we believe loan issuers—and especially older vintage private loan issuers—could be at risk of higher defaults if the economy softens and/or rates stay elevated.
Three key takeaways
- Income driven return outlook remains favorable.
- Be careful with what you own.
- Prefer bonds versus loans due to quality and upside price potential.
