As the economy goes, so goes high yield
Three things to watch in 2022.
Potential for a massive wave of high-yield security upgrades While debt rating upgrades have far outnumbered downgrades in 2021, most were within the high-yield market. We believe 2022 will see a dramatic increase of high-yield companies being upgraded to investment-grade—some 17% of the high-yield market, per J.P. Morgan estimates—as companies that were downgraded to high yield in 2020 return to investment-grade status. This will have two impacts. First, the upgraded companies should see their spreads (the difference between their yields and those of comparable maturity U.S. Treasuries) tighten, generating relative performance. Second, as these bonds are upgraded, high-yield managers will look to redeploy those assets back into the high-yield market, creating a favorable supply-demand dynamic.
The economy We expect 2022 to be another year of above-trend economic growth. Periods of strong economic growth tend to favor the high-yield market as corporate earnings rise, credit measures improve, defaults stay low and credit spreads tighten. We are closely monitoring risks to our projection of strong economic growth, which would include a significant flare-up of Covid-19 hospitalizations and deaths, as well as the impact from supply chain issues affecting specific issuers and industries.
High-yield issuance trends Historically, there has been a lagged correlation between certain types of high-yield issuance and subsequent default rates. Over the past few years, the largest use of proceeds from high-yield bond issuance has been to refinance existing debt, typically at lower costs and for longer terms. Generally, when the use of proceeds switches over to higher-risk activities (acquisition financing, dividends, stock buybacks and leveraged buyout financing), higher defaults tend to follow a couple years later. The fourth quarter of 2021 witnessed a subtle shift to a somewhat more aggressive use of proceeds, albeit still within historical norms. If this trend were to accelerate and spreads continue to remain tight, an adjustment to our overweight high-yield recommendation may also need to change.