The primary threat to the high-yield market isn't a wave of corporate defaults, but rather a reversion of the compressed risk premium that investors demand. This premium has been historically low, and a return to normal levels presents a significant valuation risk, even if fundamentals remain stable.
The CCC-rated segment of the high-yield market should not be treated as a simple down-in-quality allocation. Instead, it's a "stock picker's" environment where opportunities are found in specific, idiosyncratic situations with high conviction, such as a turnaround story or a mispriced part of a company's capital structure.
In the current market, where valuations are tight, the potential return from being fully invested in high-yield is not compelling enough. Therefore, the opportunity cost of holding extra cash is low. This strategy allows for reserving liquidity (dry powder) to deploy opportunistically when dislocations or better entry points appear.
In a market where spreads are tight and technicals prevent sustained sell-offs, making large directional bets is a poor strategy. The best approach is to stay close to benchmarks in terms of overall risk and allocate the risk budget to identifying specific winners and losers through deep, fundamental credit analysis.
LMEs became popular because issuers could exploit out-of-court processes to their advantage, often by playing creditors against each other. As creditors have become more collaborative, this advantage has diminished, making LMEs less beneficial for issuers and likely capping their future frequency. Vanguard treats all LMEs as defaults.
The modern high-yield market is structurally different from its past. It's now composed of higher-quality issuers and has a shorter duration profile. While this limits potential upside returns compared to historical cycles, it also provides a cushion, capping the potential downside risk for investors.
While lower rates seem beneficial for leveraged companies, the context is critical. The Federal Reserve typically cuts rates in response to a weakening economy. This economic downturn usually harms issuer fundamentals more than the lower borrowing costs can help, making rate-cutting cycles a net negative for high-yield credit.