Brandywine Global, a specialist investment manager of Californian-based Franklin Templeton, has just released its mid-year outlook on US and structured credit.

Portfolio managers at Brandywine Global Bill Zox and John McClain highlighted on Thursday the benefits of investing in short-duration US high yield bonds and investment grade credit in the second half of 2023.

“Short-duration US high yield can be a dangerous part of the market. There is often a good reason why these bonds have not been refinanced when they are close to maturity,” they said in a statement. However, this time they believe it is different. They find it to be one of the most attractive parts of the market, and they see a lot of high-quality opportunities on the front end of the curve.

“There are many high yield bonds that are likely to be called in the next year or two or that mature in the next two to three years. Their spreads are reasonable, but when you combine that with the inversion of the Treasury yield curve, you get very high single-digit yields for good high yield credits that we believe have minimal risk of default,” they continued.

“Furthermore, there is greater visibility to companies’ business models over the next two or three years versus farther out, and these management teams have had time – and access to capital – to prepare for higher interest rates and recession,” they said. In their view, this segment has one of the best risk/return profiles across bond markets because, in spite of not taking much duration risk, investors are still getting paid a significant yield. “There are opportunities farther out on the high yield curve as well, but we really think it is an optimal time to focus on the front end. However, skilled active portfolio management will be valuable if the market becomes irrationally concerned about the likelihood that certain short-duration bonds will be refinanced,” they added.

Defaults expected to remain subdued
“Supporting the case for high yield is a potentially benign default outlook. Defaults are increasing modestly but are still very low. In most cases, high yield issuers are servicing fixed-rate debt obligations with highly inflated assets and cash flows, which makes it much more difficult to default. For example, interest coverage continues to be elevated at near record levels,” they said.

“Meanwhile, the smaller, more aggressive leveraged financings have been taking place in the leveraged loan and private credit markets. This trend makes sense as the high yield market has been relatively stable in size over the last 10 years while first leveraged loans and then the private credit have grown rapidly. This demand from the rapidly growing leveraged loan and private credit markets has been satisfied with lower-quality issuance,” they said. As a result, they expect leveraged loans and private credit to absorb more of the defaults than the high yield market in this credit cycle.

Opportunities
While they are more constructive on US high yield, they do see some opportunities in the investment grade space. “One is regional banks, although given the risks, you must be judicious and well diversified. It is possible we will see more issues in banking, but we know the sector’s importance to the US economy. Regional banks will end up with access to reasonably priced debt and equity capital," they said. And if banks do come under further pressure, they would expect the fallout to be even worse for other parts of the financial markets that do not have the same implicit and explicit support from the government. Some high triple B, low single A regional bank bonds trade at spreads as wide as high yield, and that will not persist; their spreads will return to well inside of where they are now, in their view.

“Despite the recent pressure on oil and gas prices, higher-quality energy issuers are attractive because the management teams have become much more disciplined capital allocators after the difficult lessons learned in 2016, 2018, and 2020. Non-bank financials also are compelling as they should benefit from any tightening of lending standards by banks,” they continued. “They have exposure to non-bank consumer lenders, auto lenders, and mortgage originators and servicers. As the banks back away from some opportunities, the lending environment likely will become less competitive for some of these non-bank financials,” they added.

An attractive entry point for high yield
“Some asset allocators may be waiting to build exposure to high yield until spreads widen further. Their approach to the high yield market involves spread-based “rules” formulated during the recessions in the early 2000s and the Global Financial Crisis of 2008-2009. These investors may be waiting for spreads to reach 600 to 800 basis points, or even wider,” they said. However, they believe that those targets are outdated and should be adjusted lower.

“The high yield market and the broader leveraged finance market have changed dramatically over the last 10 years. High yield has improved, becoming much more of a BB-rated market than a B-rated one. And the secured part of the high yield market has been growing rapidly while subordinated high yield bonds have dwindled to next to nothing,” they continued. “Lastly, high yield issuers have become larger, and they are more likely to have publicly traded equities. These strong fundamentals may help keep high yield spreads contained such that today’s spreads of 400 to 600 basis points are comparable to the 600 to 800 basis points seen in prior cycles. Adding a reasonable high yield spread to a very attractive Treasury yield results in all-in yields that should produce attractive returns over time. Passing up current spread and yield levels may mean passing up a good entry point for increasing a strategic allocation to US high yield,” they said.

Meanwhile, given cheapening valuations and more uncertain fundamentals, hampered by the after effects of Fed tightening, credit tightening, less appetite for long-duration assets from banks, and slower economic growth, portfolio manager Tracy Chen believes valuations will likely have more downside. She will continue to be defensive and cautious by pivoting investments up in quality, up in the capital structure, and short in duration within various sectors. She believes that the most attractive opportunities include: current coupon agency MBS [mortgage based security]; seasoned CRT [credit risk transfer] securities rated BBB and BB; non-qualified MBS rated AAA; seasoned subprime auto ABS [asset based security] AAAs to BBBs; CLO [collateralized loan obligation] AAAs; and seasoned commercial MBS AAAs to As, among others.