As published in CFA Institute Enterprising Investor on August 3, 2023
Markets were generally buoyant in June as participants focused on positives while events with negative implications for asset prices, like higher risk-free rates, were largely ignored. The ICE BofA US High Yield Index faced resistance in the low 400bp OAS range, which is consistent with where resistance has been for much of the past year.
We believe that patience will be rewarded as certain areas of the market have run further than is justified by fundamentals. Momentum and FOMO appeared to be driving price movements in June. An expensive market that becomes more expensive is one of the more difficult setups for a fundamental- and valuation-driven approach to positioning. Despite a market that is fully priced overall, some attractive individual opportunities remain for those willing to search for them.
Six months ago, it looked like the US high yield market was likely to be range bound over the near term, and it would be challenging for the market to rally beyond the low 400bp range in spread. Even though the market broke through 420bp several times over the past six months, including at the end of June, this could be viewed as a sign that the market is overextended, rather than the market transitioning to a new tighter-spread reality.
There are plenty of signs of late-cycle dynamics, with the increased cost of capital of the past 18 months yet to be felt by much of the market. Some have pointed to price action in response to the AI craze and have drawn a comparison to the late ‘90s tech bubble, arguing that there are years left to go until the peak. We believe the current market environment is likely an echo of the speculation-driven bubble of 2021 that was characterized by cryptocurrencies, NFTs, meme stocks and SPACs. There were some spectacular short-term run ups in stocks like AMC and Bed Bath & Beyond well into 2022. It is probably a bad sign if the main market driver can be characterized as a craze and the argument for being invested in the craze is to point to the ‘dotcom’ bubble, which was so detached from reality that the Nasdaq index fell by 80% following its peak, during which time the Federal Reserve cut its policy rate by 4.25% on a net basis.
While hawkish messaging from central banks hurt fixed income markets generally in June, a higher-for-longer regime benefits floating rate securities, including leveraged loans and rate re-set preferred shares. The market has been pricing in higher long-term rates than the Fed dot plot for months now, but June’s updated forecasts showed relatively significant movement amongst FOMC voters, with seven of 17 respondents now projecting a long-term policy rate of over 2.5% In March there were only four such projections and for comparison, a year ago only two. It could be argued that these projections are still well behind the curve but are slowly acknowledging that the facts have changed.
There are cracks and structural problems in several areas of credit markets, probably no more so than in commercial real estate, with a lot of mortgage maturities coming due in the next couple of years. While this is not news to the market, the impact has not been fully appreciated. In leveraged finance, the lack of CLO issuance could push more issuers to the high yield market, increasing the pricing power for investors and the cost of capital for issuers. Now may be a great time to have excess capital to tactically deploy in the coming months as the opportunity set may improve.