Yield Comparison Report – 27 September

Report 27 September

Yield Comparison Report – 27 September

by Kaushal Mehta, Sagar Joshi and Suneet Chandvani

The Debtwire Yield Comparison Report presents a relative analysis of US high-yield versus Treasury, Mortgage debt and dividend yield of US business development companies (BDCs) holding middle-market debt. The report analyzes the interest rate environment and current spreads, while comparing historical data and inferring future expectations. We also highlight the current yield curve to capture the bond markets’ expectations of economic activity and inflation.

Treasury Yields vs CPI

The Consumer Price Index (CPI) increased by 60bps to 3.7% in August from 3.2% in July versus 3% in June, but significantly lower compared to the peak of 9.1% in June 2022. The recent spike is largely attributable to increase in prices of gasoline, housing, energy, and food. The two-year and 10-year treasury yield stood at 5% and 4.6%, respectively, as of 26 September, the highest levels seen in the last 12 years. This indicates that despite the substantial reduction in inflation, interest rates have remained sticky, largely due to 11 rate hikes implemented between March 2022 and July 2023. On 20 September, the US Federal Reserve kept the rates unchanged at 5.25%-5.5%, while citing expectations of one more rate hike before the end of the year and signaling higher-for-longer rates with lesser than forecasted rate cuts in 2024. It continues to reduce bond holdings, thereby downsizing the central bank balance sheet, the FED is allowing up to USD 95bn of maturing bonds to roll off each month. Notably, this is the fastest and the steepest rate hike cycle in the last 16 years, comparable to the cycle preceding the 2007 housing market crash.

In contrast, the 10-year and two-year treasury spread dropped to negative 48bps as of 26 September, staying negative since July 2022. This signifies an inverted yield curve, which is highlighted in the chart above and analyzed in detail below.

The above chart compares the current yield curve versus historical yields over three, six and 12 months. The front-end of the curve has spiked in the last one year, with three-month rates rising to 5.57% from 3.39%. The inversion is the highest since 1981, historically indicating the possibility of a recession in 3-12 months. However, the yield curve’s predictability in the current interest rate environment is yet to be seen, particularly in the context of US GDP rising 2% in 1Q23 and 2.4% in 2Q23. Also, the curve has been inverted for more than a year (since July 2022), while the equity markets have recovered significantly, with S&P 500 and NASDAQ up 12% and 26% YTD and 17% and 21% YoY, respectively, aided by expectations of an end in the rate tightening cycle. Nevertheless, high interest rates have burdened the balance sheets of highly levered and non-investment grade companies.

Debtwire’s August 2023 Restructuring Insights report recorded a 74% YoY increase in bankruptcies in August (1H23: 36% YoY increase), with 33 new cases filed (1H23: 143 cases) versus 19 cases filed in July and 16 cases filed in August 2022. Additionally, Debtwire’s Watchlist for September 2023 recorded 311 companies with USD 360bn of debt compared to 225 companies with USD 255bn of borrowings in September 2022. According to Debtwire’s August 2023 US Leveraged Highlights, the YoY decline in leveraged loan issuance (31%) and new money leveraged issuance (58%) has been substantial in August (see image below for details).

Source: Debtwire’s August 2023 US Leveraged Highlights

Comparing High Yield vs Treasury Yield vs Middle Market Yield

The red line in the chart represents the current dividend yield (10.5%) of the VanEck BDC Income ETF (BIZD) as of 25 September. The blue line displays the BofA Merrill Lynch US High Yield (US HY index, currently at 8.72% as of 25 September), which tracks the performance of USD-denominated below-investment grade corporate debt publicly issued in the US. The yellow line displays the 5-year treasury yield, 4.6% as of 25 September.

As of 25 September, the spread between the US High Yield and the five-year treasury (green line; an indicator of credit market risk) was 410bps, below the one-year average of 455bps and a consistent decline since last one year. This means even in such high interest rate environment with the high cost of debt for new capex, refinancing risk for existing debt, overall slowing demand and increasing bankruptcies, high-yield companies (mostly rated below BBB− or Baa3) offer on average just 400bps more than similar duration US treasuries, considered to be the safest instrument in the world, depicting the hunger for yield and the ability of the market participants to take on additional risk. The question remains is the high yield high enough to compensate for the longer to stay higher interest rates?

The spread of BIZD dividend yield and the US High Yield (gray line) represents the premium or discount of middle-market loans over traditional high-yield borrowings. As of 25 September, BIZD dividend yield was at a premium of 181bps to the US High Yield Index, lower than the one-year average of 231bps. The premium, to some extent, depicts credit risk and illiquidity of private loans with middle market companies.

BIZD’s weighted average market capitalization is USD 4.6bn, with PE of 11.14 and PB of 0.97 as of 31 August. The entire portfolio comprises of publicly traded BDCs, which are lenders to privately held middle-market enterprises that tend to be below-investment grade or not rated, with most lending comprising senior secured loans.

Comparing High Yield vs Debtwire Bond Index

The orange line displays the US HY Index, while the blue line is Debtwire Bond Index (DWBI) yield, representing bonds of companies in the Debtwire Watchlist (highlights bonds of levered borrowers that are either engaged in balance sheet restructurings or face imminent pressure to reduce debt, usually trading below 80) for the respective month. DWBI is used to assess the state and size of the distressed bond universe. In September, DWBI captured approximately USD 158bn of outstanding bonds, with YTM of 19.81%, a decline of 52bps from August. The spread of DWBI and HY stood at 11.4% as of 15 September, down from 12% in August. This indicates a potential recovery in distressed companies, aided by stabilizing rate environment. Below are our recent reports on stressed/distressed situations, along with bond and loan momentum monitors: