He argues that while the flood of capital into private debt has worked well for investors, it might prove to be a far riskier bet than high yield, which used to represent peak risk in fixed income.
"(Moving to private debt) has worked well, but it has been a function of interest rates and floating-rate debt rather than the underlying health of the asset class," Leary said. "Because it has worked well three, four, five years ago, there has been an obscene amount of capital that has chased that trade."
"You're approaching $1 trillion in size for an asset class where there is very little transparency, zero liquidity. If you look into what we can assume for the ownership of these entities, a lot of sponsor-owned/private equity-owned companies are taking out this debt."
"That lack of liquidity is a design function, not a design flaw. The balance of power has moved to those equity issue owners," Leary said. "You don't have to mark to market; you don't really understand what's really happening under the hood."
"When we start to see a slowdown, that's when you're going to start seeing the cracks," he said.
Randy Parrish, managing director, head of credit and a senior high-yield portfolio manager at Voya Investment Management, said it makes sense to talk more about high yield now.
"When high yield was at 4.5%, it was a little hard to make a case for the asset class. Let's be honest. But at 8.5%, it looks different," Parrish said. "The income is better and so is the ability to absorb a backup in rates or widening of spreads. There is the ability to absorb some credit volatility. It's not wildly cheap by historical standards, but it's not wildly rich."
Brian Kennedy, vice president at Loomis Sayles & Co. and co-portfolio manager on the full discretion team, said that high yield has shrunk in size over the past 10 to 15 years, which has led to a higher-quality market.
Back then, high yield had about 55% to 60% of the levered finance market, Kennedy said. Now, high yield has an equal share with bank loans and private credit, with about 33% of the levered finance market, he said.
Many investors have gone to these new markets to find returns during the long period of central banks suppressing interest rates since the global financial crisis of 2008.
"What we've seen in the syndicate bank loan market," Kennedy said, "the rise of acceptance in CLOs (collateralized loan obligations) has really tilted issuance in favor of bank loans in the most recent past, the last two, three, five years."
As a result, "the high-yield market doesn't look a lot like the high-yield market of old," Parrish said.
"The market quality distribution is skewed much higher today," Parrish said. He noted a greater share of the market is BB rated than it was 10 or 15 years ago. According to Fitch Ratings, as of June 30, 51% of high-yield issuers were BB rated and 11% were CCC rated, compared with 10 years previously when 40% of the market was BB rated and 18% was CCC.
"There's a lot of reasons for that," Parrish said. "We haven't seen the aggressive financing in high yield in recent years. … I think you play that forward obviously through a downturn. One, you have fewer markets. Two, you probably have better recovery than other places."
One reason that high yield might have a better recovery than other, riskier asset classes such as private debt is that more junk bond issuers are also securing their debt. During the week of Sept. 11, for example, 12 high-yield issuers raised $9.6 billion, about 55% of which was secured by company assets, according to J.P. Morgan.
"We're also seeing a lot of the deals that are coming in being secured in the high-yield market, the better part of the cap structure," said David Forgash, managing director and portfolio manager at Pacific Investment Management Co. According to Informa Global Markets, of the $122.6 billion in high-yield issuance in the year to Sept. 19, slightly more than $74 billion — or 60.4% overall — has been secured.
"There is also the lower cash price. The average price of a high yield bond is 89 (cents on the dollar)," Forgash said. "In the past all high-yield bonds or almost all high-yield bonds were callable, but when you're priced at a discount you get that lovely word of convexity."
A bond's convexity measures the sensitivity of a bond's duration to changes in yield .
"The total return potential is higher in high yield than in the past," he said.
For the year ended June 30, the Bloomberg U.S. Corporate High Yield index returned 9.1%.
Forgash also noted that currently the companies that access the high-yield market are bigger companies than they've been in the past, which also leads to the market's reduced risk.
"The average size of companies have $1 billion of EBITDA and better access to equity," Forgash said. "About 45% of these companies have public equities, so they have the ability to use that equity side to lever if they have to."
"When people think about high yield sometimes they lose sight of what a large and diverse market it is, and that a name like Ford today is in the high-yield market," said Kevin Lorenz, head of high yield and a portfolio manager at Nuveen.
Standard & Poor's cut Ford Motor Co.'s credit rating to BB+ in March 2020, one step below investment-grade following the shutdown of North American factories in response to the COVID-19 pandemic.
"It's one of our larger holdings, and we think it's directionally moving into investment-grade," Lorenz said. There have been a number of downgrades from investment-grade that have come into the high-yield market, he said.
"What the market is pricing — which some people don't always appreciate — is how much healthier, how much stronger the high-yield market is today than it has been over time," Lorenz said.
In 2007 prior to the Great Recession, Lorenz said high yield had a very different landscape.
"There was less than 40% BB and even more importantly a materially higher percentage in CCC, about 20%, and that is not always appreciated," Lorenz said.
"It continues to be our view that prior recessions are not a very good proxy for the kind of downside scenario for high yield in this case," Lorenz said.
The base-case forecast currently has about 3% to 4% of the high-yield market that will be in default in a coming recession, "as opposed to other recessions, where you're typically at 10% to 12% default rates or higher," Lorenz said.