Outlook 2022: Junk returns expected in 1.5%-5% area in year ahead; volatility offers opportunity

By Abigail W. Adams

Portland, Me., Dec. 31 – High-yield secondary trading witnessed a largely uneventful year as the market hovered around all-time tights.

Given this, it was the new issue market that was the driving force of liquidity in the space, and coupon clipping served as the driving force of returns as the Federal Reserve’s monetary policy continued to bolster risk assets.

While there were pockets of volatility throughout the year, the moments of weakness were brief and the trading activity muted with buyers and sellers gridlocked at the market’s current level.

However, that has already started to change.

With the Federal Reserve unwinding its easy money policies, the high-yield secondary market is expected to become a much more volatile and active space in 2022.

Junk returns in the coming year are expected to range from 1.5% to as much as 5%, according to the forecasts of several investment banks.

Coming volatility is also expected to yield opportunity with market players eyeing short strategies, beta plays and spread compressions through ratings upgrades as areas to generate alpha.

While market players offered divergent views of where to find the best opportunities, all were in consensus about the pending volatility.

“2022 is going to be a very different year,” a source said.

Muted volatility, trading

It was an uneventful year in the high-yield secondary market with volatility low as the market steadily ground tighter.

Credit spreads were their widest at the start of the year at 384 basis points in January 2021, according to data provided by BofA Global Research.

However, spreads tightened as the year progressed with positive earnings and a dovish Federal Reserve bolstering risk assets.

While the overarching trend throughout the year was in a singular direction – up – there were temporary pullbacks as the market attempted to price in a shift in monetary policy.

The U.S. 10-year Treasury yield hit its highest level of 1.778% in late March as the Federal Reserve began signaling an end to pandemic stimulus through bond tapering.

Low coupon, longer duration bonds were particularly hard hit by rising Treasury yields as investors reduced their rate risk.

However, trading volumes were light in the midst of the volatility with holders reluctant to sell.

“Nobody wants to sell low today only to have it shoot right back up tomorrow,” a source said of the stagnation in the market.

And shoot back up it inevitably did.

By June, credit spreads hit 304 bps and the CDX index traded up to a 110 handle – record levels for junkbondland.

Correction chatter was strong in the market, especially entering into third-quarter earnings.

However, the bull run continued into the final months of the year.

Credit spreads were 315 bps at the end of October, according to BofA Global Research.

But in the final weeks of the year, the market changed.

The temporary pullbacks showed signs of a growing trend as the long-speculated shift in monetary policy became a reality.

Credit spreads pushed out to 367 at the end of November with CCC index the hardest hit with a 79 bps widening and BB credits pushing out 45 bps, according to BofA Global Research data.

The Federal Reserve’s hawkish turn officially came on Dec. 15 when chair Jerome Powell announced a more aggressive timeline for bond tapering and a dot plot with three rate hikes scheduled for 2022.

However, the high-yield market responded favorably with the more aggressive timeline in line with market expectations.

“Powell stayed very close to the line the market was already pricing in,” BofA analyst Oleg Melentyev said.

Credit spreads saw nominal improvement and stood at 349 bps on Dec. 16.

While tightening credit spreads helped bolster the market in the first half of the year, coupon-clipping was the main driver of returns in 2021.

“It is a running joke among HY investors that this market rarely delivers a coupon return, and yet this year it did exactly that,” BofA analysts wrote in the BofA Global Research report “High Yield Strategy: Year Ahead 2022.”

The ICE BOFAML U.S. High Yield index posted returns of 4.696% on Dec. 16.

Scenarios for returns vary in 2022. Some are predicting similar returns in the 4% to 5% range with credit spreads continuing to hover at their current level.

Others see a widening of credit spreads and returns in the 1.5% area in the coming year.

However, in each scenario, there is a common theme – the Federal Reserve.

Return forecasts

While the market shifted in the final weeks of 2021, the year largely belonged to the bulls who were bolstered by a dovish Federal Reserve stressing patience in the roll back of pandemic stimulus.

While there is still an argument for a bull market in 2022, the probability of that scenario is low with many viewing the market’s performance in November and December as the start of a growing trend.

Market players pointed to a range of potential headwinds in 2022 with underpriced risks from geopolitical tensions, a change in tax policy, or a vaccine immune Covid-19 strain among them.

However, monetary policy and its impact on valuations are widely considered to be the dominant force impacting the market in 2022.

While Federal Reserve policy could continue to support a bull run in 2022, a slow and steady normalization of monetary policy is widely regarded as the most likely scenario to transpire.

BofA analysts see a base case of 2.5 rate hikes in 2022 and a five-year Treasury yield of 1.3%.

Credit spreads are expected to hover around 300 bps with the high-yield market generating total returns of 4% to 5%.

While nominal spreads of 300 bps are the historic tight for the market, the level is reasonable considering the market’s current credit composition, BofA’s Melentyev said.

Defaults are at historic lows, and the fundamentals of issuers are strong.

“The high-yield market has never had more BB credits and less CCC credits than it does today,” Melentyev said. “Is the 300 bps you were paid in 2007 when BBs where half of the market the same as today?”

The fundamental strength of the market is expected to continue in the new year with an issuer default rate of 2%.

Morgan Stanley analysts are projecting two rate increases in 2022, in September and December, to be followed by three rate increases in 2023.

Treasury yields are expected to steadily climb next year with 10-year Treasury yields projected to reach 2.1% by the end of 2022, according to the Morgan Stanley report “2022 US Credit Strategy Outlook: Patience is a Virtue.”

In Morgan Stanley’s base case scenario, high-yield spreads are expected to be in the 330 bps range with total returns of negative 0.1% and returns of 0.6%.

If inflation tempers and the Federal Reserve takes a dovish approach to its rate hike timeline, analysts see a scenario where spreads could push past the historic 300 bps barrier.

In such a scenario, BofA analysts see spreads going as tight as 250 bps to 275 bps in the coming year.

The scenario would be “difficult given the yield/price constraints but not impossible,” according to the BofA report.

With a supportive macro backdrop, Morgan Stanley sees a bullish scenario where high-yield spreads compress to 240 bps, defaults go as low as 1% and returns reach 4.6%.

However, market players have long anticipated and are already positioning themselves for a reversal in the market.

“Most people think valuations are stretched and it’s an easy point to make,” Melentyev said. “When valuations are stretched, the direction they go when they change is relatively clear.”

A more aggressive rate hike schedule, slowing U.S. growth and a persistent yearly inflation rate of 5.5% would fuel the bearish scenario outlined by Morgan Stanley analysts.

In the bearish scenario, high-yield spreads could push out to 475 bps, defaults could rise to 3% and returns could hit 6.2%.

With credit conditions the loosest in years, the high-yield market is highly susceptible to a risk reset, according to the BofA report, with historic episodes seeing credit spreads push out 200 bps to 400 bps.

However, the period of volatility is expected to be temporary with a full turnaround in the credit cycle unlikely given the strong fundamentals of the market.

“We firmly believe that even if such a correction were to occur in coming months, it should prove temporary and fail to cause a large-scale default wave,” analysts wrote in the BofA report. “This means the recovery should follow the initial sell-off quickly.”

Some market players are eyeing that coming volatility as a long-awaited opportunity.

High-yield returns in 2022 projected by other banks include Barclays at 3% to 4%, Citigroup and Deutsche Bank both at 1.5% and JPMorgan at 4.4%.

The opportunity

Looking ahead, the hunt for yield could be particularly fierce in 2022.

The new issue market was where money was put to work in 2021 – a theme which is expected to remain in the coming year.

However, additional opportunities will present themselves as market volatility increases.

A short strategy for rate-sensitive bonds, beta plays riding the volatility wave, and spread compressions through rising stars and rating upgrades were all pointed to as areas to generate alpha in the coming year.

Market players have long anticipated a pivot in Federal Reserve policy and a trend reversal in the secondary space.

However, for many, that reversal has been eyed as an opportunity.

“People are waiting for a pullback,” a source said. “But they’re waiting for it because they want to buy.”

While BofA analysts are recommending moderate de-risking in preparation for a volatility episode, they also recommend betting against a downturn in the market.

With spreads expected to widen, entry points for fundamentally strong high-yield issuers will become more attractive.

It is an opportunity many have been waiting for.

Shorting rate-sensitive credits was a strategy that proved effective in the final months of 2021 and may continue to reap rewards in the coming volatility, a source said.

Spread compressions from rising stars and rating upgrades will also present attractive opportunities in the coming year, sources said.

High-yield upgrades marked $420 billion in October, which is a 70% reversal of the downgrades undertaken during the height of the Covid-19 pandemic in 2020.

However, rising stars have only accounted for $43 billion of those upgrades, marking a 29% reversal rate for fallen angels, according to the BofA report.

Issuers have opted for an investment grade/high yield, secured/unsecured hybrid when tapping capital markets, in lieu of a full rating upgrade.

However, BofA indicators are eyeing $70 billion currently in the high-yield index that is one rating upgrade away from achieving rising star status.

Kraft Heinz Co., Centene Corp. and HCA Healthcare Inc. are the companies with the largest capital structures that are expected to rejoin the investment-grade index over the next 12 months.

“It’s not just high-quality BB,” Melentyev said. “Low BB and single B also have the potential for such upgrades.”

While the added volatility will provide added opportunity in the coming year, the safest play will be more of the same, sources said.

“Pick your spots, trade new issues, clip your coupons, and avoid anything dangerous,” a source said.

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