What’s Up With High Yield

William Ahmuty, Head of the SPDR Fixed Income Group, recently interviewed Fixed Income Beta Solution’s Senior Portfolio Manager Bradley J. Sullivan, CFA, on the current opportunities within high yield fixed income. Mr. Sullivan manages the Corporate Credit systematic investment team. The team manages index and quantitatively driven strategies across multiple investment vehicles including: ETFs, commingled funds, and separately managed accounts.

How would you sum up high yield markets in 2023, and what are your views on 2024?

2023 was a series of peaks: peak inflation, peak rates, peak oil and commodities, peak credit quality, peak equities. Well, on second thought, not peak equities. But this is a credit conversation that we are having. The overall credit quality of high yield was the best it has ever been in 2023, and the market showed great resiliency despite macro volatility.

Only recently has quality begun to ebb, due primarily to the sheer abundance of rising stars that have graduated into investment-grade — well-known names like Ford, Apache, Occidental Petroleum, Sprint, and Netflix. The high yield market overcame numerous and wide-ranging macro events, such as ongoing geopolitical risks in Ukraine, emerging turmoil in the Middle East, auto union labor strikes in the US, and financial sector weakness from a small-scale regional banking crisis.

The current market has benefited from the Federal Reserve’s (Fed) transparency and consistency in fighting inflation. The dramatic move higher in interest rates had a larger impact on bond prices than the corporate earnings cycle did. As high yield securities traded down in sympathy with rising government rates (the 10-year US Treasury yield increased by 330 basis points (bps) over the two years, leading to its 5% peak in October 2023), many issuers were able to deploy a portion of their operating cash flow to repurchase their bonds at significant discounts to par. (In late September 2021, the average dollar price of the Bloomberg High Yield Index was above $105, and precisely one year later it had fallen below $85. By early 2024, average prices climbed to the low $90s.)

Despite concerns about a slowdown, one market characteristic we typically don’t see ahead of a recession is a shrinking debt market. Believe it or not, the par outstanding of the Bloomberg Corporate High Yield Index in March 2024 is actually less than it was nine years prior in March 2015. We might expect excessive leverage and accelerated corporate debt growth as symptoms of an overheating market and precursor to an eventual recession, but we aren’t seeing that today. This contrasts with the previous interest rate regime, especially during the COVID market when significant issuance of bridge debt was used to build cash war chests to withstand the economic shutdown.

We expect this market resiliency to continue throughout 2024. Corporate fundamentals appear intact, with support from strong consumer demand and prudent balance sheet management. Another positive is that new issuance has picked up, which alleviates concerns about the “maturity wall.” The new issue composition has been tilted toward higher quality borrowers; nonetheless, we have also seen lower quality borrowers able to issue. One barometer for a healthy debt capital market is the ability to price debt across the risk spectrum. We have concerns regarding further geopolitical escalations and commercial real estate deterioration, but the market’s focus will likely transition from Jay Powell’s ability to stick the soft landing to the impact of the US election.

Can you discuss the technical side of the high yield market?

Technically speaking, the high yield market is pretty boring right now. Since the larger issuers have graduated to investment-grade, there are fewer very large capital structures to trade. BB spreads are near all-time tights. CCCs are the same familiar issuers; there hasn’t been a new wave of concerned credits or emerging trends in more challenged industries. It’s interesting that the stressed names are in more defensive sectors like healthcare and telecom, typically a late-cycle observation.

The recent issuance has created more two-way liquidity, which contrasts to 2022 when the market was binary and traded on the bid or ask and rarely in the middle. Although we see some pent-up demand for issuance, we still see opportunistic issuance that indicates more of a balanced market than 2022.

We are watching issuance preference between the private debt and leveraged loan markets, compared to the public high yield market. Well-known, seasoned issuers are able to issue debt at relatively tight credit spreads. There continues to be ample dry capital on the sidelines, regardless of whether it stems from private equity firms, CLO formation, private credit funds, or traditional high yield bond buyers. Some of the expectations for private credit growth suggests that we may see broad corporate re-leveraging over the next three to five years.

What is your approach to assessing credit risk in high yield portfolios? Are there particular metrics you’re watching?

Given our investment philosophy, we look at three key metrics when evaluating credit risk, all at the security level. We look first at the security’s credit rating and then we examine two market factors: spread and yield. This gives us both a qualitative and quantitative approach to assessing credit risk.

For the credit rating, we utilize ratings published by Nationally Recognized Statistical Rating Organizations (NRSROs). These NRSROs take a proprietary quantitative and qualitative approach to measuring overall financial health and creditworthiness of each issuer, but there are two universal concerns with credit ratings. One is that credit ratings can become stale and lag market events because they depend on company-issued financial data. The second is that the qualitative analysis has a human component to it, which can lead to certain biases in the rating.

The credit spread is a real-time reflection of the issuer’s perceived credit risk, but this also has its limitations, as the spread may be subject to short-term distortions in the market, especially for bonds with very short times to maturity. There are also some inconsistencies in applying the reference Treasury bond to calculate the spread.

Yield is typically calculated on a yield-to-worst basis, to account for the call protection in high yield bonds. Given that most prices in the market today are below par, we are adjusting this calculation to take into account the accounting treatment of long-term debt becoming “current.” Most issuers rely on refinancing debt as a primary source of repayment. Financial auditors typically will not give a corporate filer a clean audit opinion if that company cannot repay its current debt within the next 12 months. We have seen research analysts adjusting current yields higher, at times between 30 and 50 bps, based on this calculation adjustment.

We offer several different index exposures to high yield at SSGA. Can you explain what they are and what type of investor might be attracted to each of them?

SSGA’s high yield investment capabilities have evolved with our product suite. Like most investors in a new asset class, our first strategies were up-in-quality, very liquid, and short duration, so they controlled for a given type of investment risk: credit, liquidity, and interest rate risks. Our first high yield strategy was focused on BB-rated and B-rated issuers. As the high yield market grew in both size and trading volume, we added high yield strategies that were more liquid and had shorter duration. Given the attractive risk-adjusted returns of high yield, investors demanded broader market exposure and customized portfolios.

In 2021, we launched a global high yield strategy that included USD emerging market corporates and non-dollar below-IG bonds. Last year, we launched our first high yield systematic credit strategy, Enhanced High Yield, which tilts security weightings from a bottom-up perspective based on valuation and price momentum factors.

Our ability to manage these customized and quantitative strategies has been largely supported by market structure evolutions, including the use of electronic trading platforms and broader trading protocols such as portfolio or basket trading.

Given our strong foundations and 30 years of expertise in the market, we build customized investment strategies to meet the investment needs of our clients.

How does the growth of the high yield market and the fixed income market’s evolution translate to the ETF vehicle and SSGA’s high yield ETFs?

We currently have three high-yield corporate bond ETFs, with each one offering different attributes and objectives: The SPDR® Bloomberg High Yield Bond ETF (JNK), the SPDR® Bloomberg Short Term High Yield Bond ETF (SJNK), and the SPDR® Portfolio High Yield Bond ETF (SPHY).

Let’s start with JNK, since this fund's success has been a direct result of market growth and evolution. I mentioned that our first strategy was focused on bonds rated BB and B. This was a strategy designed for a limited market. As the high yield market grew and witnessed advances in technology, and as new trading protocols created greater efficiencies, we graduated to managing a very liquid indexed high yield strategy. Seeking to invest in the most liquid bonds in the market with extraordinarily few constraints, JNK can be used as both a tactical trading tool and as an allocation within multi-sector portfolios. (Note that historically, the most liquid high yield bonds traded at spread premiums to the broader high yield market.) We also use the JNK price trend and premium as a guide to pricing activity on electronic platforms and portfolio trades, along with guiding clients on transaction cost analysis (TCA) for institutional flows. We have focused on making JNK the “cheapest” high yield ETF to trade in size.

To me, SJNK is a derivative of JNK, as it focuses on the shorter duration bonds in the high yield arena. By limiting or constraining the portfolio’s duration, we have built an ETF that maintains liquidity while mitigating the impact of interest rate changes. This is a good strategy for the investor interested in capturing credit moves within the high yield market but dampening duration risk. SJNK has also shown outperformance versus some floating-rate ETFs that focus on below investment-grade issuers.

And finally, SPHY is our core buy-and-hold solution for gaining long-term broad high yield exposure. SPHY holders can monetize the liquidity premium derived from off-the-run bond issues, which can be unlocked over longer investment horizons.