Fidelity Institutional
November 14, 2023
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Preparing for a changing credit cycle

Why higher rates may eventually lead to increased distressed investment opportunities

Commentary
What’s different in corporate credit
Since early 2022, the fed funds rate has increased at its fastest pace since the 1980s,
leading investors to rapidly adjust to a world of higher market interest rates, steeper
inflation, and more interest rate volatility.
An environment of higher rates could have unintended consequences, including
more future volatility in what currently appears to be a still-healthy high-yield bond
market. Over time, this could lead to an increase in the number of companies that
fall into distress, given the significantly higher cost of capital.
This could negatively affect leveraged firms—especially capital-intensive
companies with low interest rate debt that comes due in the coming years. The
rising cost of capital could be a prolonged problem for borrowers—potentially
for the next five years or longer (see “The rising cost of capital and its investment
implications,” written by the Fidelity Asset Allocation Research team).
Preparing for a changing
credit cycle
Why higher rates may eventually lead to
increased distressed investment opportunities
KEY TAKEAWAYS
Dispersion among U.S. high-yield bond issuers has risen along with interest rates.
Historically, when dispersion has risen, distress in the high-yield market also
has tended to rise, offering investors opportunities to take advantage of credit
dislocations.
Transition in the high-yield market has been orderly so far, largely a function of still
sound corporate finances.
Yet as refinancing needs increase in 2024 and beyond, so too may the challenges
of adjusting to higher interest rates.
Brian Drainville, CFA
Institutional Portfolio Manager
Fidelity Investments
Preparing for a changing credit cycle
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2
Source: BofA Securities, High Yield Credit Chartbook; data from 8/31/03 through 8/31/23. Reprinted by permission. Copyright © 2023
Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or
interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided “as is”
and none of BAC or any of its affiliates warrants the accuracy or completeness of the information. Dispersion is calculated at the end of each
month as the percentage of the par value of bonds in the BofA U.S. High Yield Bond Index trading +/- 100 bps or more from the index
spread. For example, this would include the par value of all index securities with a yield spread above 485 bps or below 285 bps (i.e., +/-
100 bps of index average spread of 385 bps as of 8/31/23). Dispersion differs from distress. Distress is the ratio of the par value of bonds
priced as distressed (more than 1000 basis points yield spread) compared with the total index par value.
EXHIBIT 1: Yield spread dispersion within the BofA U.S. High Yield Index
In time, these market dynamics could lead to more yield spread dispersion in the high-yield
bond market, which has already happened to a degree. Yield spread dispersion (we’ll refer to
it as dispersion going forward) is calculated at the end of each month as the percentage of the
par value of bonds in the BofA U.S. High Yield Bond Index trading at least 100 basis points (bps)
in either direction from the index spread. Dispersion has risen over roughly the last two years,
coinciding with higher interest rates and reduced pandemic spending by the federal government.
Why high-yield dispersion matters
Exhibit 1 shows that as of August 31, 2023, high-yield bonds in the index are now back at the
average dispersion of the past 20 years, with 70% of index market cap trading at least 100 bps
from the index average yield spread.
The highlighted time frames in green in Exhibit 1 show the transition periods from high to low
dispersion dating back to the 2007–2009 Global Financial Crisis.
100%
80%
60%
40%
20%
0%
2003
2005
BofA U.S. HY index dispersion
Average dispersion from August 2003
?
2007
2009
2011
2013
2015
2017
2019
2021
2023
Preparing for a changing credit cycle
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3
Mar ‘09–Feb ‘11
Jan ’12–Jun ‘14
Feb ‘16–May ‘18
Apr ‘20–Jun ‘21
BofA Distressed High Yield Index
72.2%
17. 6%
32.3%
81.7%
S&P 500 index
3 7. 2 %
22.0%
17.7 %
52.7%
BofA High Yield Index
35.9%
11. 5%
11.1%
2 0 .1%
Rising dispersion could be considered a precursor to market distress, since increased yield spread
differentiation often coincides with rising sector and issuer volatility. This is evident in Exhibit 2, which
combines the dispersion time series from Exhibit 1 (x-axis) with the corresponding time series of the
proportion of high-yield bond face value that qualifies as distressed (y-axis, see definition below).
Exhibit 2 displays, as a scatter plot, the same time series from Exhibit 1 (the yield spread dispersion percentage within the index on the X-axis)
and the percentage of distressed debt within the index relative to the total on the Y-axis. Each dot reflects month-end data. Source: BofA
Securities, High Yield Credit Chartbook; data from 8/31/03 through 8/31/23, gathered on 9/1/23. Reprinted by permission. Copyright © 2023
Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or
interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided “as is”
and none of BAC or any of its affiliates warrants the accuracy or completeness of the information. Dispersion is calculated at the end of each
month as the percentage of the par value of bonds in the BofA U.S. High Yield Bond Index trading +/-100 bps or more from the index spread.
For example, this would include the par value of all index securities with a yield spread above 485 bps or below 285 bps (i.e., +/- 100bps of
index average spread of 385 bps as of 8/31/23). Distress is the ratio of the par value of bonds priced as distressed (more than 1000 basis
points yield spread) compared with the total index par value.
Date ranges in the exhibit represent the four largest dispersion spikes since March 2009. Source: Bloomberg L.P., as of 8/31/23.
EXHIBIT 2: Dispersion and distress within the BofA US High Yield Index
EXHIBIT 3: Annualized investment returns for distressed high yield following past dispersion spikes
90%
60%
30%
0%
30%
40%
50%
60%
70%
80%
90%
100%
BofA HY index issuers: Distressed as a percent of total
Yield spread dispersion percentage within BofA High Yield Index:
Face value with yield spread outside 100bps of index yield spread as a percent of total
June 2021
Pandemic Recovery
Current
March 2020
Pandemic Onset
November 2008
Financial Crisis
Over the past 20 years, the level of dispersion and distress in the high-yield bond market reached
extremes on several occasions. As of the fall of 2023, the level of dispersion and distress is far
lower than at the beginning of the pandemic but well above the mid-2021 lows.
Importantly, past market dislocations have shown that when distress increases, so too can the
prospects for distressed investment returns. Exhibit 3 displays the annualized total return of
distressed high-yield, the S&P 500, and the broad high-yield market corresponding to the shaded
periods in Exhibit 1.
Preparing for a changing credit cycle
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4
When high-yield spread dispersion normalized from wide levels, the distressed portion of the
high-yield bond market has provided very competitive investment returns.
Still, high-yield looks healthy
Despite the increase in dispersion and distress over the past two years, we have not yet seen a
significant increase in the number of companies falling into default—at least to date. As of August
2023, the share of distressed debt in the high-yield index stood at 7%, below the historical average
of 11% dating back to 2003. This is a function of the current strength in U.S. high-yield credit. The
ability to service debt among high-yield bond issuers has remained near a multiyear best for both
net leverage and interest rate coverage metrics (Exhibit 4).
EBITDA is earnings before interest, taxes, depreciation, and amortization. Source: BofA Securities, High Yield Credit Chartbook, 8/31/23.
Reprinted by permission. Copyright © 2023 Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any
of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information.
The information is provided “as is” and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.
EXHIBIT 4: Fundamentals of high-yield bond issuers
Supply-demand dynamics in the high-yield market also remain supportive, helping to keep
credit stress contained. Many companies locked in debt during the pandemic-induced low-rate
environment of 2020/2021. As a result, as of May 2023, 84% of leveraged credit issuers had no
refinancing needs before 2025.
1
Pre-Pandemic
(Dec 2019)
Height of the Pandemic
(Dec 2020)
Aug 2023
Net Leverage
(net debt/EBITDA)
4.3x
5.2x
3.6x
Interest Coverage
(12-month EBITDA/Interest)
4 .1x
3.3x
4.8x
Preparing for a changing credit cycle
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5
Leveraged debt is defined as high yield bonds and leveraged loans. Forward leveraged debt maturities for each year reflect the percentage
of total outstanding two-and three-year debt coming due in the future. Source: “2023 midyear outlook, high-yield bonds, and leveraged
loans,” JPMorgan Chase & Co., Copyright © 2023, as of 6/30/23.
EXHIBIT 5: The approaching leveraged debt maturity wall
25%
20%
10%
15%
5%
0%
2007
Q4
Q2
2009
2011
2013
2015
2017
2020
2008
2010
2012
2014
2016
2018
2019
2021
2022
2023
2-year and 3-year forward leveraged debt maturities (as a percent of the outstanding debt)
2-year
3-year
What could lead to more credit dispersion?
Credit spreads have yet to widen meaningfully despite the backdrop of rising interest rates. In fact,
the high-yield bond index yield spread is now at its narrowest in the last twelve months and below
its 10-year average.
2
That said, here’s what we’re watching: the amount of leveraged short-term debt coming due is
expected to increase over the next two to three years (Exhibit 5). Over roughly the next 24 months,
just under 9%
3
of the leveraged debt market (high-yield bonds and leveraged loans) is scheduled
to mature.
This share jumps to near 22% when looking out 36 months.
3
This is projected to be the highest
level of refinancing needs in over a decade. For some firms, refinancing may soon turn from a
choice to a need, and some of these needs could be challenged given the dramatic change in
interest rates.
Preparing for a changing credit cycle
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6
As this is happening, banks are becoming less willing to lend. The blue line in Exhibit 6 measures
the change in lending sentiment of senior loan officers. A higher blue line suggests tighter lending
standards. As of July, 2023, there is a wider gulf between this measure and the BofA U.S. High
Yield Index Yield Spread (green line) than at any point in 25 years. This suggests expectations for a
tighter credit backdrop are not reflected in current market pricing.
RIGHT: Lending conditions based on the U.S. Federal Reverse Senior Loan Officer Survey. It measures the net percentage of domestic
survey respondents (up to 80 large domestically chartered commercial banks and up to 24 large U.S. branches and agencies of foreign
banks) that are tightening lending standards, relative to those that are loosening lending standards. A higher survey reading indicates tighter
lending conditions. Source: Bloomberg L.P. and BofA Securities. Reprinted by permission. Copyright © 2023 Bank of America Corporation
(“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such
information or acts as any endorsement of the use of such information. The information is provided “as is” and none of BAC or any of its
affiliates warrants the accuracy or completeness of the information. As of 7/31/23.
EXHIBIT 6: Tighter lending standards that are not reflected in the high-yield spread
1800
1200
600
0
100
60
80
0
–20
20
40
–40
1997
2001
1999
2003
2005
2007
2009
2013
2011
2015
2017
2019
2021
2023
BofA High U.S High Yield Bond Index spread (bps)
Lending condition C&I loans for large/medium co. (higher = tighter; RHS)
BofA U.S. High Yield Index spread (bps; LHS)
*4)/4,(54)/;/54:Ķ./,.*9/:;/,.;*9ķ
Conclusion
We don’t believe the divergence in Exhibit 6 can last. In a changing credit cycle, idiosyncratic
risk could rise, as some companies adapt to the shifting market dynamics better than others.
With history as a guide, we would expect to see a corresponding rise in distressed investment
opportunities as this adjustment plays out over the next several years.
Overall high-yield index pricing could decline, although in a new credit regime, there could be
far more opportunities for security selection. This situation could be a multiyear event if higher
interest rates persist over a longer time frame.
Endnotes
1
JPMorgan Chase & Co., Copyright © 2023, “High yield and leveraged loan morning intelligence,” May 12, 2023. Figure includes bond and loan issuers.
2
Bloomberg L.P., as of 8/31/23.
3
JPMorgan Chase & Co., Copyright © 2023, “2023 midyear high yield bond and leveraged loan outlook,” June 26, 2023
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