Credit risk

Credit risk is ‘the No. 1 risk’ for high-yield investors, strategist says

Oleg Melentyev, head of high yield credit strategy at BofA Global Research, joins Yahoo Finance Live to discuss what to expect with the credit market as interest rates are set to rise.

Video transcript

JULIE HYMAN: Well, with interest rates so low, companies have issued a huge amount of debt in 2021, especially in the high yield sector. While this issuance may slow down in 2022, it could still be a popular area for investors.

Let’s talk more about the outlook for high yield with Oleg Melentyev. He is Head of High Yield Credit Strategy at Bank of America Global Research. Oleg, thanks for being here. I want to start, I think, with what is the big issue on the minds of investors across all asset classes, which is rising rates. What are the particular implications for high yield of the outlook that the Fed will change the balance sheet and raise rates?

OLEG MELENTEV: Yeah, so high yield, I guess there are two things to know about this asset class. First and foremost, the number one risk for investors is credit risk. And the good news is that these two things usually go in the opposite direction, which means you either have increasing credit risk or interest rate risk. And so right now, of course, it’s time to be more concerned about interest rate risk, which happens to be a secondary consideration for high yield investors — again, simply because exposure to this risk is lower.

That said, it’s a risk. We’ve seen the Fed pivot essentially 180 degrees over the past two months, and that’s certainly something on the minds of investors today.

BRIAN SOZZI: Oleg, we have a lot of traders on our platform who don’t know the credit markets too well or follow them as closely as you do. Do you see anything in the credit markets that could soon trickle down to the portfolios of equity investors?

OLEG MELENTEV: Then yes. There is therefore a link between these two markets. They are not perfectly correlated and in fact most of the time they could go their own way depending on their own techniques and fundamentals. But if you see extreme pressure in one corner of the credit market, equity investors will usually know about it. Such extreme pressures don’t happen often by definition, and we don’t necessarily expect them to happen in 2022.

So given the risk of rising rates and the potential fallout on credit and to some extent on high yield, we don’t expect this to derail the high yield market, but that it still have some effect on it.

JULIE HYMAN: And in your most recent note, Oleg, you looked at particular areas where we may have seen misallocation of capital due to loose financial conditions, due to the abundance of liquidity. Tell us about some of the areas that could be most at risk in this environment.

OLEG MELENTEV: Sure. Yes, so it’s something we do frequently. We like this approach of basically following the money, don’t we? We don’t always kind of know the ultimate solution to, you know, some of the macro trends, but following the money is a simple approach that helps us understand where potential excesses might be developing.

And so we did, as you mentioned, just in this last note, and we identified three areas where the increase in debt, the increase in indebtedness has been the greatest. These include transport, automobile and utilities. And if you think – just take a step forward from here and just think what’s a common denominator across these sectors, one is they’ve all been exposed to COVID. So to a certain extent, you can say, listen, these aren’t necessarily the normal capital raises that have happened here. This is in response to COVID. These companies have rebuilt their balance sheets.

Perhaps the other common denominator between them is that they focus more on ESG investors simply because infrastructure is a big part of those streams and portfolios. And so maybe to some extent we’re starting to see an over-allocation of capital based on the popularity of ESG mandates.

JULIE HYMAN: And what then are the implications for these particular areas? Are there then higher default risks? What is it…yes?

OLEG MELENTEV: Well, I think, first and foremost, you want to be aware of what those flows are, and you want to be kind of aware of the potential for, say, creating overcapacity in those sectors. Once you have overcapacity, it’s harder to maintain profitability. Once you have that, margins are under pressure, and it all comes down to the quality of the balance sheet and the quality of the income statement.

So I wouldn’t necessarily go immediately from, you know, seeing a large inflow of capital to a higher risk of default, but it certainly puts you in a corner of the market where you just spend a little bit more time analyzing the sector and observe some of the other metrics.

JULIE HYMAN: That’s right, and it also suggests what we already know, which is that a lot of businesses, especially when you’re talking about transportation, are currently very stressed in this area.

Oleg, thanks for being here. Oleg Melentyev is the Head of High Yield Credit Strategy at Bank of America Global Research. Thank you.