During that time, CCC-rated credits have outpaced the overall market, delivering 21.6%. These returns are even more impressive if we look at the deeply distressed cohort of the market (rated Ca and below), which returned 31.5%. Clearly, lower-quality credit has been on a historic run over the past five quarters.

Rewind the clock…

Positioning going into 2023 was universally bearish. Throughout the year, investors scrambled to add paper in illiquid names as fears around an imminent recession faded. Lower-quality bond prices jumped higher. As the year went on, the precipitous drop in inflation coupled with resilient economic data gave credence to the soft-landing narrative – one that continues to propel financial markets higher. Valuations reflect this optimism.

So, the question is: where does the high-yield market go from here?

In the current climate, it’s hard to envision anything but a CCC rally driving the market tighter. Despite the recent outperformance, lower-quality credits remain one of the only pockets of the market not trading meaningfully through historical averages. Indeed, BB- and B-rated credits lack the headroom between current levels and their historical limitations.

Is now the time to add CCC risk?

Let’s take stock. The US economy is more robust than many predicted. The US Federal Reserve (Fed) has largely brought inflation under control (albeit with bumps along the way). Rate cuts, although pushed out, remain on the horizon. These factors should support high-yield corporates across the ratings spectrum over the coming quarters.

The argument that CCC-rated credits are the last-remaining source of value is therefore persuasive. The high-yield market closed the first quarter at an option-adjusted spread (OAS) of +299 basis points (bps). Since the Global Financial Crisis (GFC), high-yield spreads have flirted with an OAS of +300bps only a handful of times. During these periods, CCC-rated credits traded meaningfully tighter to the overall market than they do today. This implies room for further compression by CCCs. Intuitively, this makes sense. Periods of tight credit spreads (market optimism) logically go hand in hand with an appetite for lower-quality risk.

Today’s CCC-rated companies are in decent shape. Many spent the low-interest-rate years of 2020 and 2021 repairing their balance sheets. In fact, the average coupon for CCC-rated companies stands at a post-GFC low of 7.24%, over 200bps below the peak rate in 2010.

This is important. Free cashflow for lower-quality names is often minimal. Interest payments are a substantial proportion of their cost burdens. Lower interest payments therefore flow to the bottom line, increasing overall cashflows.

But the decline in coupon costs is unique to CCC-rated names. Conversely, the wider market has seen a material uptick in coupon costs over the past year.

What explains this? First, a lack of new CCC-rated issuance over the last few years meant historically low coupons have failed to reset higher. Second, a hot loan market has been a viable financing option for lower-quality names. Third, the private credit sector has taken on the bulk of leveraged buyout funding.

We also know monetary policy operates with long and variable lags. And, as we mentioned, lower-quality companies are sensitive to a change in funding costs. As a result, we think CCC-rated names are only starting to feel last year’s Fed rate hikes. That could spell trouble. In 2018, restrictive monetary policy and a looming maturity wall meant CCC-rated credits struggled.

So, where does that leave us? There’s a lingering argument that lower-quality names could tighten as investors reach for yield. Nonetheless, we don’t think there’s enough justification to allocate substantial capital to the distressed portion of the market where creditor-on-creditor aggression has left many capital structures uninvestable.

Where are we investing?

We prefer improving single Bs and regular CCCs. That includes troubled sectors, such as cable and wireless, which are excellent hunting grounds for value.

We’ve taken chips off the table in consumer-facing sectors. Namely, leisure/cruise lines, retailers and autos, where valuations don’t compensate for the reality on the ground. We will remain selective on new issues. It feels like many market participants are investing indiscriminately, with little upside. We’re also ensuring the liquidity of the portfolio is up to par. This includes using instruments, such as credit default swaps and US Treasuries to ensure we can be nimble when appropriate.

Many improving CCC-rated credits can withstand today’s unforgiving environment. However, troubled credits that have benefited from a rising tide will struggle in the future. We’ll only know the success stories when market euphoria fades. In the meantime, we remain selective in lower-quality credits, investing in those names with repeatable cashflows, termed-out debt structures, and substantial equity cushions.

Final thoughts…

When we put history aside and turn to the present, we think the market is attractive versus alternatives. A 7.5%-8% yield gives investors an equity-like return in the form of income. This not only enables additional potential for total returns, but also provides a cushion against downside risks in case the consensus view of a soft landing turns out to be inaccurate.

Source: Bloomberg, 2024. For illustrative purposes only. No assumptions regarding future performance should be made.