Update on High Yield Bond Issuer Fundamentals

Posted on August 13, 2021

Expectations that high yield issuer fundamentals will continue to improve as the economic recovery gains momentum are driving lower default expectations over the intermediate term. High yield issuer fundamentals, after a very difficult calendar year 2020, are already improving at an impressive pace. Much of the poor operating performance by companies was generated during the first half of 2020, shortly following the onset of the pandemic, with results then beginning to show modest quarter-over-quarter improvements during the third and fourth quarters of 2020. The pace of improvement reported in the first quarter of 2021 should accelerate further as the rate of economic growth, supported by the broader reopening of the economy, continues to increase, with such results expected to be reflected in second quarter numbers that will soon be reported.

More specifically, based on JP Morgan’s report on aggregate first quarter 2021 operating performance and credit metrics for high yield issuers, both revenues and EBITDA increased on a quarter-over-quarter (1Q 2021 versus 4Q 2020) as well as a year-over- year (1Q 2021 versus 1Q 2020) basis. Perhaps most impressive, EBITDA, aided by margin improvement, grew by over 10% in the first quarter relative to the fourth quarter of 2020. One can view such margin improvement with cautious optimism, as it serves as evidence that companies in the high yield market in the aggregate were able to pass on some of the higher input costs to their customers via price increases.

However, as the exhibit below illustrates, leverage increased sharply during 2020 and continued to remain very elevated at the end of the first quarter. This heightened leverage is primarily the outcome of a significant decline in EBITDA in 2020 as the necessary but economically damaging lockdown and other mitigation restrictions were implemented in an effort to curtail the spread of the coronavirus. Fortunately, leverage should improve relatively quickly because as each new quarter passes by, another difficult quarter from 2020 will be removed from the leverage calculation and replaced with the most recent quarterly results. In fact, as a result of projected EBITDA growth, some forecasts call for leverage to return to pre-pandemic levels as soon as the end of this year.

High Yield Bond Market: Historical Leverage



The improving fundamentals have already led to a material increase in the number of high yield issuers upgraded by credit rating agencies this year. Notably, the number of high yield issuers upgraded exceeded the number downgraded each month thus far in 2021, a feat which only occurred in one month over the previous fourteen prior to December 2020. We expect this trend to continue over the balance of 2021, as issuer fundamentals continue to improve with stronger economic growth. In addition, upgrades typically result in price appreciation, as spreads further compress to levels consistent with the new (and improved) credit quality of the bond. The decrease in spread, and thus the potential for price appreciation, is especially pronounced if a bond is upgraded from high yield to investment grade, as the average spread on BBB-rated investment grade bond is almost 150 basis points lower than that of a BB-rated high yield bond.

Interested in reading more? The above post is an excerpt from our 2021 mid-year CIO Perspective. We invite you to access the full document, available below. 

CIO's Perspective: 1st Half 2021 Leveraged Credit Review & Outlook


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