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Weekly ETF Brief

High Yield Still on the Up

It has been a tough first half of the year for bond investors. Those who put money to work on the final trading day of 2023 would only be close to breaking even had they invested in an all-maturity Treasury fund, and would still be well in negative territory looking at the global aggregate.

Temps de lecture: 5 min
Senior Fixed Income ETF Strategist

But not all corners of the market have been as challenging. The three tenets for successful fixed income investing so far have been: 

  1. stick to the front end of the curve, as inverted curves provide little incentive to extend; 
  2. avoid duration risk to minimise underlying price sensitivity to market yield changes; 
  3. take on some credit risk as the carry from credit spreads has helped to offset the negative price impact of rising yields.

So Far, so Good for High Yield, but What Next?

High yield strategies have ticked all of the boxes. They are typically short duration, for the main part because non-investment grade issuers keep issuance to within the first five years on the curve,1 and there is a meaningful credit spread. Returns year-to-date have been positive2 and, at a basic level, new highs in equity markets hint that investors remain in a risk-on frame of mind. 

However, clouds are gathering over the outlook. Data suggests that the US economy is slowing which could put pressure on corporate balance sheets, not least because the financing put in place, largely in the low rate environment of 2021, is starting to roll off, necessitating issuance at far higher interest rates. Credit spreads are now historically tight, leading to questions about whether investors are adequately compensated for taking on the additional credit risk.

Financial indicators of risk are not yet signalling any major stresses. The upgrades/downgrades ratio for non-investment-grade issuers remains below 1 in the US but it is off the recent lows seen in Q4 2022. The Bloomberg US Corporate Bankruptcies Index has now headed lower from levels seen in mid-2023. In Europe, lower absolute yield levels, in part due to the ECB delivering the first cut in the cycle, coupled with an improving economic backdrop should ease the headwinds for high yield.

A Strong Starting Point

While there has been some recent spread volatility, the all-in yield of high yield strategies remains appealing. In the Q2 Bond Compass we explained why the combination of the high yield coupled with the short duration provided investors with protection against a market sell-off. It remains the case that the breakeven (yield-to-worst/duration) on the Bloomberg US Corporate High Yield Index is at over 250 basis points (bps) and for the Bloomberg Liquidity Screened Euro HY Index is above 280 bps. So yields would have to move higher by these amounts before the price losses on the index fully offset the annual yield.

There is another way of looking at risks around returns and that is the degree to which the current yield correlates to the return. In the case of high yield, the relatively short duration means that the high coupon rate is a meaningful component of the ultimate return that the strategy provides. The figures below illustrate this fact: the 12-month historical returns from the respective Bloomberg US and Euro indices (lagged 12 months) are shown against the yield, i.e., the index returns are aligned with the index yield on offer when the allocation decision would have been made. There is a relationship between the strong returns seen over the past 12 months and the yield seen at the time of investment, 12 months ago. The correlations of the 12-month returns to the yield is above 60% for both the US and Euro high yield indices.

Looking at a regression of the yield versus returns variables shown in the figures above highlights that, from the current starting yield (7.9% for US and 6.1% for Euro high yield), there have been no cases over the past 10 years where 12-month returns would have been negative.3 Of course, past performance is not a reliable indicator of future performance, but this should give investors some comfort that, to the degree that history can be a guide, the strong current yield characteristics of high yield funds are a strong driver of investment performance. 

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