Outlook 2024: Soft-landing scenario to net positive returns; market CCC wary

By Abigail W. Adams

Portland, Me., Dec. 29 – After a year of intense debates about rates, recession and refinancing risk that sparked dramatic repricings in markets, the high-yield secondary space is closing 2023 at the height of the year and as the best performing fixed income asset class.

Most gains occurred in a short time frame with an explosion of inflows and buyers in November lifting the high-yield index a historic 4.6 points.

The explosive gains continued after the Federal Open Market Committee announcement on Dec. 13 with the index adding 2 points in two days.

The Fed and the market had reached consensus that the rate hike campaign had come to an end and rate cuts would soon begin.

Markets widely anticipate a soft-landing scenario for the economy with the Fed to start loosening monetary policy in the coming year.

But the rally that drove credit spreads to their tightest and returns to their highest in 2023 is not expected to sustain itself.

Spreads are widely forecast to widen and returns to moderate even as the market receives its long-coveted rate cuts.

And while the soft-landing scenario is widely forecast to net positive returns in 2024, those forecasts are still shrouded with uncertainty.

The rate cut path will remain murky, particularly in the first half of 2024, with recession debates still raging as market players eye the economic conditions that will cause the Federal Reserve to loosen monetary policy.

Refinancing risk will also come to the fore as CCC credits attempt to address their looming maturities.

CCC credits have seen shifting fortunes in 2023 with the segment outperformers for much of the year as what a source coined the “most telegraphed recession in history” failed to materialize.

However, they are closing the year suspect with up-in-quality credits in demand as market players prepare for an economic slowdown.

A November to remember

The high-yield secondary market is closing 2023 as the outperformer among fixed income asset classes with the market netting double digit returns after a phenomenal late-year rally.

The market was strong throughout the year with CCC credits outperforming as the resilience of the economy took markets by surprise.

Market players entered the year positioned for a recession, which many saw as the inevitable outcome of the Fed’s historic rate hike campaign.

It was “the most telegraphed recession in history,” a source said.

And it failed to materialize.

There were some market shocks early in the year as the banking sector showed its vulnerability to the hike in interest rates.

In rapid fire succession, Silicon Valley Bank, Signature Bank and First Republic Bank collapsed in March 2023.

Credit spreads blew out to their widest of the year at 522 basis points with returns on a 1% handle as concerns about the stability of the banking sector rattled markets.

However, the crisis was quickly contained and the economic data throughout the year remained strong with the resilience of the labor market and the consumer unexpected.

Some badly beaten credits that entered 2023 as strong default candidates were the best performers of the year.

Used car e-commerce company Carvana Co.’s 10¼% senior notes due 2030 (Ca/CCC-) closed 2022 in the 40 range, a distressed debt trading level that few credits recover from, a source said.

The 10¼% notes now trade in the mid-70s with a successful distressed debt exchange completed in August and some now bullish on the credit.

While strong economic data helped drive the performance of CCC credits throughout the year, the performance of the broader high-yield index was varied as the same data continued to fuel the great rate debate.

It was a rocky road for much of the year as the market priced then repriced rate expectations with a large portion of the market anticipating additional rate increases in the final quarter of 2023.

Then came November.

Conflicting economic data points throughout the year converged to paint a picture of decelerating inflation, a softening in the labor market and continued resilience in the economy.

The markets cheered as the Fed seemingly achieved its soft-landing.

Inflows and buyers flooded the secondary space as Treasury yields plunged from the highest level in decades with the narrative shifting from rate hikes to rate cuts.

Inflows in November hit $13 billion, reversing all outflows year to date.

November netted a monthly return of 4.6%, the top percentile for monthly returns in the history of the market, said Oleg Melentyev, BofA credit strategist and author of the report “High Yield Strategy: Year Ahead 2024.”

The spectacular gains continued after the FOMC released its dot plot plan on Dec. 13 with 75 bps of rate cuts penciled in.

The ICE BofAML US High Yield index added more than 2 points in two days with returns at an annual high of 12.368% and spreads near their tights at 372 bps.

And while the broad market saw a rally of historic proportion into the final weeks of the year, the CCC index, the outperformers for much of 2023, were laggards.

The high-yield bond market closes the year as the clear winner of 2023 among fixed income asset classes with the CCC credit tier the outperformer.

The S&P U.S. High Yield Corporate Distressed Bond index netted year-to-date returns of 21.56% as of Dec. 14. The ICE BofA CCC index is logging year-to-date returns of 13.6%.

However, the phenomenal gains of the high-yield market over the past month and a half are expected to moderate in the coming year with the fortune of CCC credits already shifting.

The market will be wary of weak credits in the soft-landing scenario that is widely expected as the economic slowdown takes its toll.

A soft landing

The high-yield market entered 2023 with the full expectation for a recession, which did not occur.

It is now entering 2024 with the consensus that there will be an economic soft landing with rate cuts set to begin.

The high-yield market was the clear winner as the market priced in the scenario.

And while the market is expected to net positive returns in the year ahead, its outperformance is not expected to continue.

The soft landing has become a catch phrase for markets over the past two years. And while the market is now at a consensus that a soft landing will occur, there has been no real definition of it.

The common ingredients in descriptions are a slowdown in economic growth and a weakening of the labor market without a recession.

The economy is widely expected to feel the lag effects of the Federal Reserve’s rate hike campaign in the coming year.

However, the extent of the slowdown and the severity of the impact is a matter for debate.

There will be some pain among highly leveraged and rate sensitive credits in the coming year, according to the Goldman Sachs report “2024 Global Credit Outlook: Back in the saddle.”

However, economic growth is expected to remain robust with rate cuts pushing spreads past their current tights.

Goldman Sachs is projecting spreads remain on a 3-handle and progressively tighten throughout the year to 369 bps in the fourth quarter.

Total returns are projected to be 8.6% with excess returns a much more modest 3.6%.

JPMorgan is projecting below trend economic growth in 2024 and a weakening in company fundamentals with spreads expected to widen as the Fed delivers 100 bps of rate cuts in the second half of 2024, according to the credit research report “2024 High Yield Bond and Leveraged Loan Outlook.”

Spreads are expected to push out to 475 bps by year-end.

However, JPMorgan is still expecting the market to deliver strong returns of 11%, a product of the high yields available in the market and falling Treasury yields.

While the economic forecasts for 2024 are largely benign, the forecasts have rate cuts baked in.

There has been an event that has caused a reversal in policy in every rate hike campaign the Fed has embarked on over the last 40 years, according to the BofA report.

While the event remains unclear, the market is expected to feel an impact before the Fed engages in rate cuts.

BofA projects the market will temporarily overshoot the extent of the impact with spreads pushing out as wide as 550 bps to 600 bps.

However, the impact is not expected to produce a recession. “There are just no bubbles we’re aware of,” Melentyev said. “It reduces the recession risk.”

BofA is projecting spreads of 450 bps with returns of about 6.6% by year-end.

The high-yield market is closing 2023 with the expectation for rate cuts and a slower, yet still strong economy.

And while the market is trading as if no recession is on the horizon, doubts remain. The market has seen dramatic gyrations throughout 2023 based on faulty rate expectations.

Forecasts during the banking crisis in March were for a Federal Funds target rate on a 3-handle by the end of 2023.

The Fed has also never been able to deliver a soft landing. “This is trading against the trend,” a source said.

A soft-landing “has never been the case. The Fed is a blunt instrument.”

Recession warning signs are still flashing, inflation continues to run well above the Federal Reserve’s 2% target, and risks to the market’s relatively rosy forecast abound.

CCC beware

CCC credits will suffer in the year ahead even in the most bullish of forecasts for the high-yield market.

Defaults and downgrades are expected to accelerate as highly leveraged companies struggle with eroding fundamentals and the increased cost of capital.

While refinancing risk was a theme in 2023, the corner of the market most susceptible to the risk has been largely untested.

CCC issuance was scarce in 2023 with refinancing needs for looming maturities still a future problem.

Those issuers will begin to test the market in the coming year, and the results are not expected to be pretty.

Performances in the secondary space became increasingly credit specific in 2023 with well-known and well-liked credits able to access the market on reasonable terms with secondary market performances strong.

Credits that were out-of-favor were punished, sources said.

Tenneco Inc.’s 8% senior secured notes due 2028 (B1/B) were a notable example with the $1.9 billion issue that priced in August to clear hung debt from Apollo’s buyout of Tenneco coming with an original issue discount of 85 to yield 11.933%.

While well wide of the B index, the notes did not price cheap enough, sources said.

They have spent the entirety of their life in the aftermarket underwater, trading as low as a 78-handle in October before recovering in the market rally to trade on an 81-handle as of Dec. 13 with a yield of about 13%.

The dynamic is expected to persist in the coming year with more CCC credits falling out of favor.

The secondary space will be largely spared from the pain the CCC index is expected to see with CCC credits a small fraction of the broader index even with the uptick in downgrades expected.

Strong credits from resilient sectors will remain in demand although there is dissention in where the best value will be found.

JPMorgan is recommending portfolios go overweight in Cable/Satellite, Media and Telecommunications with the default projections of 2.75% for 2024 among the lowest of the big banks.

However, BofA is projecting an uptick in defaults to about 3.4% with Cable, Telecommunications and Media among the sectors with the highest default candidates.

While the high-yield market is not expecting a recession in the coming year, “there are a lot of reasons to be concerned and cautious,” a source said.

Strong companies with good cash flow and no major refinancing needs will be coveted. Highly leveraged companies with weak fundamentals are expected to fall to the wayside.

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