CCC-Rated Bonds Lose Their Luster as High Yield Continues to ShineApril 22, 2024By Stephen C. Concannon, CFACo-Head of High Yield, Portfolio Manager and Will ReardonInstitutional Portfolio Manager, High YieldKEY POINTS 1. CCC-rated and distressed bonds are underperforming in April after leading the high-yield market in total return in 2023 and in the first quarter of 2024. This comes as the high-yield market continues to outperform higher-quality fixed income alternatives.1 2. The CCC-rated segment of the ICE BofA U.S. High Yield Index returned -2.66% over the month-to-date period through April 16, 2024 relative to -1.63% for the single-B segment. 2 3. The ICE BofA U.S. High Yield Index is outperforming the Bloomberg U.S. Aggregate Index by more than 300 basis points over the year-to-date period through April 16, 2024 amid resilient economic growth, sticky inflation and sharply higher U.S. Treasury yields in April.What We Are SeeingThe blind yield grab that characterized much of 2023 and the first quarter of 2024 appears to be fading. Through the balance of last year, CCC-rated and distressed bonds outperformed the high yield market as investors chased performance and reached for yield in the one rating segment in fixed income that was not trading with historically tight credit spreads, on average. This included bonds such as the U.S. cable provider Cablevision's 5.75% coupon unsecured bonds of 2030 that rallied from trading below $45 in July of '23 to end the year above $62. Cablevision was not alone. Altice France's 8% coupon unsecured bonds of 2027 rallied from a July 2023 low under $40 to a March 2024 peak of over $70. The list goes on.This trend in CCC-outperformance appears to have peaked in late-March. After returning 20.36% for full year-2023 and 3.22% in the first quarter of 2024, relative to returns for the ICE BofA U.S. High Yield Index over the same periods of 13.46% and 1.51%, the CCC-rated segment is underperforming the broader Index by 85 bps over the MTD period ending April 16th. This shift in performance trends appears to be indicative of a broader shift in investors' focus, from momentum back toward fundamentals and credit risk. This change in focus was due in large part to recent publicly stated intent of several large high yield constituents to conduct "liability management exercises," or in other words sticking it to creditors by executing distressed exchanges and, at times, transferring valuable assets to unrestricted subsidiaries. Such behavior should not come as a surprise to seasoned high yield investors and yet in many instances this appears to be the case. The aforementioned bonds of Cablevision and Altice France traded below respective levels of $47 and $33 on the 17th of April. Many investors were caught offsides. What We Are ExpectingWe came into this year with some skepticism on inflation expectations and the number of expected interest rate cuts in 2024. We correctly disagreed with market consensus for approximately six interest rate cuts in 2024 with the expectation that the path to two percent inflation would prove more difficult and lengthier than what appeared to be priced into the market. Admittedly, we did not foresee the level of resilience we are seeing in U.S. economic growth. We expect the combination of higher-for-longer interest rates and resilient economic growth will continue to favor the relative performance of high yield versus higher-rated, longer duration fixed income alternatives. An 8.31% average yield that ranks in the widest quintile relative to the preceding 10-year period should provide ample cushion for expected credit losses and continue to attract new capital into the asset class. What We Are DoingOur strategy remains slightly under-risked relative to the Index, based on a duration-times-spread ratio that continued to trend modestly below 1. We are not becoming more defensive at this time. We are cognizant of the many supportive attributes of our market and are actively waiting for opportunities to add risk when idiosyncratic opportunities arise or market levels appropriately adjust. Wider peak spreads feel likely; however, expectations for peak spread levels are tempered. The BB share of the ICE BofA US High Yield Index again climbed back above 50% in the first quarter, and a new record-high 34% of the index is secured.4 Idiosyncratic opportunity and pockets of volatility favor an active approach that focuses on bottom-up fundamental analysis and appropriate risk compensation. The specific bonds mentioned are shown to represent the market conditions during the period. Provided for informational purposes only and should not be deemed as a recommendation to buy or sell the securities shown. Altice France is a holding in one of our strategies. Cablevision is not a holding in our strategies.1ICE data 3.31.20242 Distressed bonds are defined as bonds trading with a credit spread of 1,000 basis points or greater. 3 ICE data indices. Data as of April 16, 2024.4 ICE data indices. Data as of April 1, 2024.ICE BofA U.S. High Yield Index is an unmanaged index of below-investment grade U.S. corporate bonds.
