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In The Spotlight
In The Spotlight
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Credit sectors are reacting to the more challenging macroeconomic environment. We explore what recent performance and flows trends within high yield and leveraged loans mean for investors.
US high yield (HY) fund outflows have reached over $33 billion this year, or nearly 10% of HY assets under management (AUM) at the end of 2021. Leveraged loans (LL), which had inflows for much of the early part of the year, have recently experienced two consecutive weeks of outflows including the largest weekly outflow since March 2020. The Credit Suisse (CL) Leveraged Loan Index is down 3.3% and the Bloomberg US High Yield 2% Issuer Capped Index is down 1.8% for the month of May (as of May 25). Year to date (as of May 25), the benchmarks are down 3.2% and 9.8%, respectively. How should investors be thinking about relative value within leveraged credit?
Despite strong year-to-date outperformance of leveraged loans, the asset class continues to screen fair compared to high yield on a relative value basis. In fact, LL/HY spread ratios are in line with historical averages (see Chart). The BB-rated LL/HY spread ratio is 1.14, nearly in line with the five-year average of 1.12. The single B-rated LL/HY spread ratio is 1.05, just inside the five-year average of 1.09.
Source: Bloomberg, Goldman Sachs Asset Management. As of May 20, 2022.
On the heels of the recent sell-off, LL yields incorporating the forward curve are now above 8% for only the fifth time since the 2008-2009 financial crisis. Historically, buying both LL and HY when yields are above 8% has generated strong forward returns.
We believe both HY and LL continue to offer value. The key issues for investors to consider when investing in either or both asset classes are their views on duration and interest rates, given the convexity of HY and the zero duration plus forward curve realization for loans. Investors favoring convexity would prefer HY, with HY bonds hovering around an average price of $89, compared to roughly $94 for the loan market. In a favorable environment, HY would have more room to appreciate in value from current levels. However, investors who prefer low duration and lower volatility may look more favorably at loans.
In addition, the implied default rate for US high yield is now greater than 3%, which is in line with the 25-year average. However, given the current high yield universe has more than 50% BB-rated credits and considering the recent 2020 default cycle, 3% seems relatively high. Loan default loss expectations are similarly modest relative to spread levels.
We have experienced a recent improvement in quality of the US HY universe, with over 50% of the asset class now BB-rated versus approximately 35% historically. Furthermore, energy sector performance tends to have a significant impact on broader HY market volatility. Due to the high level of energy defaults and fallen angels in 2020, the quality mix of the sector has notably improved, creating a tailwind for the HY market for the first time in recent memory.
Each month we feature quotes from our investment team, offering a glimpse into our investment views and what we are monitoring and analyzing.
“Based on historical data, the forward return potential appears solid for both high yield and leveraged loans. Preference between the asset classes is dependent on an investor’s view of duration/rates, given the convexity of high yield and the zero duration plus forward curve realization of loans.”
Robert Magnuson, Managing Director, High Yield Portfolio Manager
Goldman Sachs Asset Management | May 2022