US high yield (HY) bonds now offer yields of 9 percent,1 just shy of the widest levels of the COVID-19 pandemic.2 While spreads sit close to historical averages, today’s absolute yield can act as a margin of safety and source of return in range-bound markets. Spreads are fair when put into the context of strong corporate fundamentals and a higher quality index; specifically, stronger balance sheets should be able to ride out economic challenges and provide an opportunity to add to a HY allocation through the year. Also, refinancing requirements for 2023 and 2024 are very low, thereby proving the necessary breathing space for corporations to navigate any challenges ahead.
High yield bond prices already reflect levels typically associated with growth slowdowns. And with a higher percentage of yield coming from the Fed’s base rate, a diversifying effect could occur in high yield, with potential lower Fed Funds rates partially offsetting wider spreads, should a bumpy landing occur (see Navigating a Bumpy Landing). High yield is also useful in working with other asset classes (notably private credit) as a liquidity tool and as a hybrid alternative to equity exposure as investors gain market clarity.
Fundamentals in US corporate credit remain healthy. Several points support HY credit profiles. Specifically, corporate balance sheets remain strong, with companies reporting robust cash positions, solid interest coverage ratios and decreased leverage (Figure 1).
Additionally, HY borrowers have taken on a conservative posture. Companies continue to curb capex, and we could be entering a longer, shallower cycle of spending cuts.
Despite the sharp increase in rising stars in 2022, the HY Index has remained higher quality due to the improvement of company balance sheets in recent years. The Index now has fewer CCC names3 (11.4% of market weight) and stronger BB credits versus 10 years ago and certainly versus pre-GFC (Figure 2).
Default rates are historically low in US HY. Though we expect defaults to rise as Fed rate hikes are digested through the economy, with the overall health of index constituents, widespread bankruptcies are unlikely. Figure 3 displays actual default rates with implied default expectations through 2023, based on current distress levels.
HY issuance fell to $102 billion in 2022, a far cry from $455 billion in 2021 and a then-record $432 billion in 2020, and down from an average of $299 billion annually over the past 10 years.3 The lack of issuance supports a bid for those higher-yielding bonds that were issued before and during the COVID-19 pandemic. We expect allocators to continue to provide a bid for higher-yielding bonds, especially if the Fed pivots to cutting short-term rates.
Maturities do not increase significantly until 2025 as HY companies refinanced at low rates and used strong cash positions to term out maturities during 2020-2021. Maturities are low in 2023 and tick up modestly in 2024; only $102 billion of HY bonds come due in the next 2 years. Overall, only 16% of HY companies have bonds or loans coming due in 2023/2024.3
However, in 2025 and 2026, more maturities come due (Figure 4) and companies will need to refinance outstanding debt. This may give the Fed and market the necessary time to rein in inflation and determine a clearer path for interest rates.
On a spread basis, we began 2023 with HY spreads of 425bps,4 in line with longer-term averages. As touched on earlier, we do expect default rates to marginally increase. However, default rates have come down from pandemic levels and remain below 2%.5 We think that investors are being paid adequately for default risk. Additionally, depressed high yield index prices, in the low $80s, reflect a margin of safety relative to defaults and related recovery rates.
Economic uncertainty could put pressure on spreads in the near-term. However, we expect a recession that is short and shallow, and an improved environment for risk assets in the next 12-18 months (see Bonds Are Poised for a Turn). Low index prices also increase the convexity of bonds, meaning that, should the environment for risk assets destabilize and spreads extend, the associated gain from falling interest rates will be felt that much more in high yield returns.
With attractive yields available in HY, there may be opportunities for investors to use HY to meet yield/ return targets in place of riskier assets such as equities, or use indexed HY as a place to park assets destined for private credit while those credit managers wait to call the money.
Alternative to Private Credit: One of the biggest trends in fixed income’s long-run bull market has been the search for yield and the propensity of investors to travel to alternative assets such as private credit. HY bonds exhibit a relatively high correlation with the returns of private credit as well as comparable yield, representing a liquid alternative useful in managing cash flows into and out of illiquid private investments (see Private Market Liquidity Considerations (ssga.com)).
Alternative to Equities: An important part of HY’s appeal hinges on its ability, over time, to deliver equity-like returns for comparatively lower levels of risk. Equities may have a difficult ride in 2023 as the side effects of Fed rate hikes hit the economy. Meanwhile, HY bonds’ strong income return provides a cushion against price declines and stagnation, in the form of carry. The current S&P 500 Index dividend yield is 1.7%,while the S&P 500 earnings yield is 4.7%.6 HY could suffer mild losses should spreads widen significantly, but the asset class carries an 8% yield in the meantime. At bottom, HY could play a hybrid role: maintaining some upside potential, while dampening the impacts of an equity drawdown as investors earn carry.
1 Yield to worst, U.S. Corporate High Yield Index, Bloomberg, as of March 16, 2023.
2 Yield to Worst, U.S. Corporate High Yield Index, Bloomberg. The highest yield of the pandemic in March 2020 was 11%.
3 Source: J.P. Morgan, as of March 6, 2023.
4 Bloomberg, based on OAS of the U.S. Corporate High Yield Index, as of January 11, 2023.
5 Barclays, Moody’s Investors Service. The November 2022 month-end default rate was 1.68% (latest data available at time of publishing).
6 Bloomberg Finance, as of Feb 24, 2023.
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