Key Points:
– Markets have been buoyant in June and July, but certain areas have advanced beyond what the fundamentals justify.
– Despite an overall fully priced market, there are still attractive individual opportunities for those willing to search.
– The US high yield market has broken through the low 400 bp range, but this may signal an overextended market rather than a new tighter-spread reality.
– Signs of late-cycle dynamics are emerging, such as the increased cost of capital and price action reminiscent of the late 1990s tech bubble.
– A higher-for-longer regime benefits floating rate securities like leveraged loans and rate re-set preferred shares.
– Certain areas of the credit markets, such as commercial real estate and the lack of collateralized loan obligation (CLO) issuance, are showing cracks and structural problems.
– Now may be a good time to stockpile excess capital to deploy tactically in the future if the opportunity set improves.
The ICE BofA US High Yield Index has faced resistance in the low 400-basis-point (bp) option adjusted spread (OAS) range, which has been consistent for much of the past year. However, despite this resistance, certain areas of the market have advanced further than what the underlying fundamentals justify. This can be attributed to momentum and the fear of missing out (FOMO) driving price movements. While it may be challenging to adopt a fundamental- and valuation-driven approach in an expensive market that becomes even more expensive, there are still attractive individual opportunities for investors who are willing to search for them.
Just six or seven months ago, the US high yield market appeared likely to be range-bound in the near term. Breaking through the low 400 bp range seemed challenging. Although the market has surpassed 420 bps several times in the past six months, this may indicate an overextended market rather than a transition to a tighter spread reality.
Late-cycle dynamics are becoming apparent, as the increased cost of capital over the past 18 months has yet to be fully felt by the market. The price action in response to the artificial intelligence (AI) craze has drawn comparisons to the late 1990s tech bubble. Some argue that it may be years until this bubble peaks. This market environment mirrors the speculation-driven bubble of 2021, where cryptocurrencies, non-fungible tokens (NFTs), meme stocks, and special purpose acquisition companies (SPACs) were all the rage. However, it is concerning when the main market driver looks like a bubble, and the rationale for investing in it is based on the longevity of the dot-com bubble, which ultimately led to significant market declines.
While hawkish central bank signals have impacted fixed-income markets, a higher-for-longer regime benefits floating rate securities such as leveraged loans and rate re-set preferred shares. The market has already priced in higher long-term rates than the Federal Open Market Committee (FOMC) dot plot, indicating a slow acknowledgement of reality.
There are several areas of the credit markets showing cracks and structural problems. Commercial real estate, with many mortgage maturities due in the next couple of years, is a particular concern. Additionally, the lack of collateralized loan obligation (CLO) issuance could lead to more issuers entering the high-yield market, increasing pricing power for investors and the cost of capital for issuers.
In conclusion, while the overall market may be fully priced, there are still attractive opportunities for investors who are willing to search. With signs of late-cycle dynamics and certain areas of the credit markets showing cracks, it may be wise to stockpile excess capital and strategically deploy it in the future if the opportunity set improves.
