US HY: Rising Stars & BBs We Like – November 2024

• On the back of an unprecedented rally following the Nov. 5 US presidential election, credit spreads snapped sharply tighter toward all-time tights, leaving us with a cautious view on credit risk. Since then, post-election exuberance has shown some signs of waning and HY spreads have widened slightly from recent tights, with BBs giving back about 10 bp over the past week.
• Even with the recent softening, valuations across US credit remain thin, leaving little room for execution risk, meriting a focus on higher quality issuers with limited near-term financing needs that are able to withstand some fundamental erosion from disappointing earnings growth and those with continued positive rating momentum.
• Within US HY, we prefer to align portfolios with BBs and issuers with positive catalysts, such as upgrades. While Bs and CCCs offer outsized yields and have performed strongly in 2023/YTD 2024, we see more downside for these issuers if growth misses expectations or if inflation surprises to the upside, resulting in fewer Fed rate cuts than previously expected.
• In the spirit of defensive trade ideas, we surveyed our analyst team for Rising Stars and other strong BB credits that we think offer reasonable spread pickup compared with BBBs and came up with 16 names across 12 sectors. We expect companies that the market deems “Rising Stars” to outperform, even if an upgrade does not materialize over the medium term, as these management teams are likely to remain focused on balance sheet strength over consolidation.

Relative Value

The post-2024 US election rally was one for the record books, with risk appetite surging on relief from a decisive outcome, optimism from business-friendly deregulatory efforts and extension of (or increases to) tax breaks. With this, credit spreads ground tighter, driving HY valuations, in aggregate, to levels not seen since before the GFC, and BBs to the tightest level since the late 1990s. The immediate post-election exuberance left us generally more cautious on credit risk as thin valuations leave little room for error, leading us to downgrade US IG and HY to Underweight with our Winner Take All: Post 2024 Election Playbook.

Looking ahead into 2025, we see three potential headwinds to credit spread stability. First, we are more cautious on the path of Fed policy easing than the market as recent economic data have surprised to the upside. On a spread basis, BBs currently trade 67 bp wide to BBBs, at the very low end of the historic range, while BB yields are a touch more compelling, trading 78 bp higher than BBBs. On a duration-adjusted basis BBs are even more attractive with BBs at 182 bp of yield per unit of duration, 99 bp more than BBBs at 83 bp. If the Fed ultimately cuts less than the market is anticipating or needs to restart its hiking cycle sometime in 2025, BBs are in better shape to absorb rising yields than BBBs, which have longer duration, or lower-rated segments, which are more sensitive to changes in borrowing costs.