Historically high yields continue to provide investors in non-investment grade bonds with meaningful return potential. Fears over growth persist but, from the current weak levels, risks look more balanced and there are several reasons why a tactical allocation to high yield during the summer could make sense.
Another rate hike from the ECB has taken the Main Financing Rate up to 4.25%. It appears that the terminal rate is close, with less than one more 25 bp rate rise priced for this year. Much will depend on the degree to which inflation continues to fall. Indeed, the weak current growth dynamic and soft growth projections of just 0.9% for 2023 suggest that growth has so far played a relatively minor part in the ECB’s policy deliberations.
The firmer growth that was supposed to have been the result of the sharp declines in energy prices has not materialised but there may be some more positive news on the horizon. The Citi Economic Surprise index for the euro area has started to turn higher from historically low levels, hinting at the possibility that the worst deterioration in the data is behind us.
Citi Euro ESI Recovering from Low Levels, Which Typically See Credit Spreads Tighten
An improvement in growth should be positive for credit spreads, in particular those at the lower end of the ratings spectrum. The chart above illustrates that, while spread levels can be fairly dependent on the regime, there is a tendency for spreads on high yield to tighten as economic surprises become more positive.
Option-adjusted spreads on the Bloomberg Liquidity Screened Euro High Yield Bond Index are at around 550 bps but still more than 50 bps wide to the 10-year average. So there is some cushion priced for the poor current growth numbers.
Weak growth has, as yet, not had a big impact on the balance sheets of lower rated issuers: the Q3 upgrades/downgrades ratio remains around 1 for Western European high yield issuers for both Moody’s and S&P.
High absolute yields also offer some protection to investors. The yield to worst on the Bloomberg Liquidity Screened Euro High Yield Bond Index is above 7.2%. The 2022 market sell-off, coupled with lower levels of issuance, has also led to a shortening in the duration of the index – it has dropped below 3 years for the first time since January 2020. Dividing the yield by the duration provides an indicative ‘break-even’ rate that has pushed above 2.5 times, close to its 10-year peak.
Seasonally, summer is usually a positive time for high yield exposures. Over the past 10 years, the Liquidity Screened Bloomberg Euro High Yield Bond Index has only posted negative returns in July once (2014) and in August twice (2015 and 2022). Seasonal factors offer no guarantees but the lack of issuance over the summer coupled with the reluctance of the dealer community to run short positions are the usual factors that provide support.
An allocation to high yield is typically viewed as a risk-on move for fixed income investors. This makes sense in the current context if growth starts to improve, inflation continues to retreat and the ECB signals a peak to rates. While this is not an improbable scenario, recent months have served as a cautionary tale in trying to predict growth, inflation and the top to the rates cycle.
Alternatively, high yield can act as a risk moderation tool if it is used as a substitute for equity. Regressing the Bloomberg Liquidity Screened Euro High Yield Bond Index against the EURO STOXX 50 shows a reasonable correlation of close to 64% but a Beta of just 0.2151. So returns are positively aligned but just less volatile.
High Yield Correlates with Equities but is Typically Less Volatile
Using high yield as an alternative to equity could provide portfolios with some protection if growth continues to slow. While this would not be a constructive backdrop for non-investment grade credit, with EURO STOXX 50 up more than 15% year to date, against returns of around 5% for high yield, there would appear to be substantially more downside risks to equities.