Olivier Le Moal
By Rachel Young
Tolerance for disappointment has worn thin.
Despite a strong start in 2023, the CCC ratings bucket has recently lost its momentum. The category has underperformed higher-quality rating cohorts since mid-September within both the high yield and leveraged loan indices by 315 and 138 basis points, respectively.1
This relative weakness has accompanied signs of bifurcation among non-investment grade issuers. In the second quarter, earnings momentum slowed following elevated growth in recent years.
The performance of CCC issuers saw the greatest divergence in operating trends, with negative year-over-year EBITDA growth, in contrast to the moderate, albeit slowing growth that BB and single-B issuers achieved.2
With third quarter earnings season underway, this dispersion of issuer performance has continued. Most issuers have been effective in navigating the current operating environment of higher rates, persistent cost inflation and evolving demand trends.
However, the market’s tolerance for earnings misses and weak guidance is thin, and trading levels have been punished for issuers that have not delivered relative to expectations.
In particular, several instances of earnings underperformance among CCC rated companies have negatively impacted the overall performance of this index cohort.
Interestingly, the weakness is less sector-specific than related to idiosyncratic situations such as unique regulatory developments, secular headwinds or operational missteps that lead to increased issuer dispersion within sectors.
To name some examples, a low-cost airline issuer saw its bonds lose nearly a quarter of their market value after reporting consecutive net income losses – in contrast to more diversified competitors that continued to deliver positive earnings growth.
A biomass pellet producer whose business hinges on long-term regulatory support announced a material contract liability and going-concern language following a series of operational and strategic lapses.
And finally, a handful of highly leveraged retailers reported softer trends and a challenging outlook as the companies face sales pressure following pandemic-induced demand for their products at a time when consumers spent more time at home.
Overall, spread dispersion has returned to a post-COVID high for the high yield market.3 However, we believe such dispersion across and within sectors provides an opportunity for effective credit selection.
While there are signs of slower earnings ahead, well-telegraphed macro headwinds have provided management teams ample time to plan and adjust their business strategies. We anticipate that bottom-up security selection will remain an important driver of performance in 2024.
1 ICE BofA CCC & Lower US High Yield Index, Morningstar LSTA US CCC Ratings Loan Index Period of September 20, 2023 to November 14, 2023.
2 Source: JP Morgan, 2Q23 high yield and loan credit fundamental data.
3 The face value of high yield index bonds trading +/- 100 basis points from the overall index average, as of November 17, 2023.
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