High yield: have the tourists left?

High carry and higher spreads before a U-turn in 2023

The tide has turned for high yield credit. Since mid-April, high yield credit has entered a new decompressing regime characterized by a structural increase in risk premium, with market participants pricing in tightening financial conditions, still elevated geopolitical risk, uncertainty around the future inflation path, a deteriorating growth outlook and increased pressures on corporate balance sheets. Liquidity is also deteriorating: US corporate bond failed trades are now higher than during the initial Covid-19 outbreak, which is consistent with a recessionary/crisis-like environment. However, there is still no clear sign of an upcoming market breakdown.
The aggregate quality of high yield credit remains relatively strong, with leverage, interest coverage, liquidity and profitability ratios remaining close to their highest levels in decades. This signals that strong cash balances may be able to provide a decent cushion for the asset class at an aggregated level in the mid to long-term. Yet, a timid increase in broad default rates is to be expected.