Corporate credit markets finished 2021 with solid returns as high yield bonds and senior secured loans returned 5.4% and 5.2%, respectively. Despite numerous challenges—a persistent pandemic, rising inflation, rising short-term interest rates, investor outflows in high yield, a transition away from LIBOR—high yield and loans posted only two months of negative returns on the year. Support from an exceedingly strong equity market in the U.S., policy accommodation from the Fed for much of the year and government fiscal stimulus early in 2021 set the stage for the positive, generally stable environment. But perhaps most important, we believe the confluence of favorable conditions created extremely strong underlying credit fundamentals. Credit issuers generated record earnings growth in the second quarter, and by the end of the year, default rates had fallen to a record low for high yield and a 10-year low for loans. With economic growth expected to remain strong in 2022, this underlying support establishes the base for our expectation for compelling albeit income-based returns in 2022.
Key takeaways
- Corporate credit markets finished 2021 with solid returns as high yield bonds and senior secured loans returned 5.4% and 5.2%, respectively.
- A supportive backdrop led to extremely strong credit fundamentals, with robust EBITDA and revenue growth and plummeting default rates in both high yield and loans. Though markets broadly face new challenges in the year ahead, we believe these strong fundamentals will provide a ballast against potential headwinds.
- With spreads near post-Global Financial Crisis tights, we forecast a predominantly income-driven return in 2022.
Similar to 2021, credit markets are faced with both new and lingering challenges for 2022. Omicron has driven new COVID infections to their highest on record while inflation, as measured by the CPI, rose to the highest level since 1982. Considering tight credit spreads at year-end, credit markets have less ability to absorb a risk-off sentiment or, for high yield specifically, higher rates from a hawkish pivot by the Fed. It is this latter point that we think has the potential to allow loans to outperform bonds in 2022. While we have written before that high yield tends to perform well in periods of rising rates, and we think that will continue to be the case, the floating rate nature of loans provides additional protection and benefits from favorable investor sentiment for floating rate product if rates continue to rise. Compared to other, higher-rated and more duration-sensitive fixed-income asset classes, we expect high yield and loans to outperform.
We are watching a number of factors in 2022 as highlighted in the next section. Inflation is a hot topic and poses both direct and indirect challenges to credit. We are also watching how the Fed reacts to this new inflationary environment. The favorable economic backdrop that typically coincides with Fed rate increases has historically supported credit markets, but uncertainty and transition from a more accommodative monetary policy will likely bring interim periods of volatility. Last, while the tight spread environment for the broad markets will likely limit price appreciation, we believe value still remains outside of traditional credit benchmarks. Collateralized loan obligations (CLOs) are one area that we think represents a unique opportunity for investors.
Even though markets will be faced with new challenges in the year ahead, we believe strong underlying fundamentals in credit will provide a ballast against these potential headwinds. Tight spreads may limit capital appreciation potential for benchmark-constrained investors, but the income generated by high yield bond and loan markets is still compelling compared to other fixed-income markets. For investors that can look beyond these traditional benchmarks, we believe additional possibilities exist to generate attractive total returns.
