In the fight against inflation, global central banks unleashed the most aggressive hiking cycle in more than two decades over the past year. Although we are finally now witnessing encouraging falls in inflation in many parts of the world, investors remain concerned about the toll this monetary policy shock will have on the economy, which typically comes with a lag.
While a slowing growth environment is challenging for companies, we expect less damage to corporate earnings than in prior downturns. This is because we are not witnessing a credit-driven downturn. For investors in high yield credit, this is encouraging.
Apart from the pandemic‑induced recession in 2020, most other recent recessions - such as the 2008 global financial crisis (GFC) and 2001 dot-com bust - have been caused by concern over the creditworthiness of certain assets. If the current downturn becomes a recession, the likely primary causes will be inflation and swift and severe interest rate hikes aimed at taming it, rather than asset bubbles.
Historically, credit-driven recessions have tended to inflict more damage to corporate earnings. For example, in the inflation‑driven recession of 1982-83, when the Fed hiked rates to 20%, S&P 500 profits fell by 18%. In the 1973- 1974 inflation‑driven recession, when rates reached 13%, profits also fell by 18%. This contrasts sharply with the GFC and dot-com crash, when profits fell by 49% and 25%, respectively.
A position of strength
While we recognise a downturn can weigh on profit margins and cash generation, which could lead to a deterioration in balance sheets, most companies have entered this period from a position of relative strength. High yield companies are underpinned by solid fundamentals, with high interest coverage ratios and relatively low leverage ratios.
In addition, most high yield bond issuers were able to benefit from attractive funding conditions in 2020 and 2021 to push out maturity profiles. Just 6% of global high yield debt matures in 2023, with the bulk of the ‘maturity walls' coming after 2025. This indicates balance sheets are broadly robust. Importantly, companies tend to have debt with varying maturities, so the impact of the rise in rates is not immediate - it is smoothed out over time.
Even though global high yield has already bounced back strongly from the extremes of 2022, investors in the asset class continue to be well compensated for risk. As a result of the sharp rise in yields last year, the yield ‘buffer' has returned. Looking at the European high yield market, where we have recently taken advantage of some compelling buying opportunities in higher quality credits, yield to maturity stood at 7.77% at the end of May. This is meaningfully higher than the average of 4.68% over the past 10 years.
Credit analysis remains key
Nevertheless, we recognise the difficult operating environment high yield debt issuers continue to face. Security selection remains critical, as some companies may not survive the slowing growth environment, despite the resilience of the broader universe. This is why fundamental bottom-up research is at the heart of our approach, which draws on the expertise of our global team of credit analysts.
In addition, as macroeconomic and political developments - along with responsible and sustainable investment concerns - can also impact performance, we supplement this fundamental credit analysis with top‑down insights from our team of sovereign and ESG analysts. This approach enables us to fully understand a company and its potential risks and rewards.
At present, we believe that Europe offers value despite its challenging growth outlook - although selectively is more important than ever The European high yield market should benefit from having less exposure than the US to cyclical markets, such as commodities. Furthermore, Europe's market is younger and less mature than the US, meaning it potentially offers more opportunities for price and information discovery, which we can potentially take advantage of with our research and active management.
