Strong economy and credit quality continue to buoy high yield
t’s been a volatile period for the markets over the past several weeks, the high-yield market included. Consider that high-yield spreads—the yield gap between high-yield and comparable maturity Treasury bonds—narrowed to 353 basis points on Oct. 3, then quickly turned, increasing to a yearly high of 432 basis points on Oct. 30. This reversal moved in tandem with U.S. Treasury yields, which increased roughly 20 basis points during this period while equities declined by 12%. Other than the expected outflows from high-yield exchange-traded funds (ETFs) as the market moved lower, the downturn was clearly related to these value adjustments in other markets.
Despite the sell-off in high yield, credit quality has remained very strong. In fact, default rates for the third quarter of 2018 came in at 8 basis points—the lowest quarterly default rate since the first quarter of 1995. Also, the distressed debt ratio, which is the percent of the market trading more than 1,000 basis points above comparable Treasury securities (and a reliable forward indicator of future defaults), fell to 3.9%, well below the historic median of 10.1%.
From our perspective, once equities stabilize, high-yield spreads should again tighten, bolstered by a strong economy, solid credit fundamentals, the conclusion of midterm election uncertainty, limited new issue supply and the return of ETF money back into the market. That said, while cycle lows in credit spreads may lie ahead, they are unlikely to move materially lower than the 353 basis points set in early October.