Tuesday, September 20, 2022
Many market participants are expecting the U.S. economy to enter a recession within the next 12 months. A Bloomberg survey of various financial institutions indicates a 50% probability of recession over this period. The high yield bond segment of the fixed income market is particularly sensitive to economic growth and stability as companies that issue high yield debt are often smaller, faster growing companies that need a strong economic backdrop to service their debt. What should high yield bond investors expect if the U.S. enters a recession in the near-term?
A common metric used to evaluate the high yield bond market is option-adjusted spread (OAS), which represents the additional yield / compensation inventors require over Treasury securities. Since 2000, the U.S. has experienced three recessions — in 2001, 2008/09, and 2020 — and the table below shows spreads six months before and after each recessionary period, as measured by the ICE BofA US High Yield Index. Given a risk-off environment, high yield bond spreads, as expected, spiked during recessionary periods and high yield bonds posted negative returns. However, this spread widening reversed following the recession. Six months after each of these recessions, spreads had meaningfully declined from the recession peak (averaging 50% decline). However, it should be noted that spreads did not tighten to levels seen six months before the recession started, indicating it takes more than six months for the high yield bond market to fully recover.
For investors willing to weather high yield bond spread volatility during recessionary periods, returns for high yield bonds have been strong 12 and 24 months following the end of the past three recessions. With the exception of the 2001 recession, domestic high yield bonds showed strong positive returns 12 and 24 months following each recession. It should be noted that twelve months following the 2001 recession, high yield bonds outperformed domestic equities (S&P 500) by more than 8%. “With the back-up in yields and spreads we’ve seen this year, the high yield asset class is offering income again,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “We think high yield bonds make sense for those income-oriented investors that are willing to stomach potential volatility.”
Year-to-date (YTD) through last Friday (9/16) domestic high yield bonds have declined approximately 12% as the market has navigated historic inflation prints and a corresponding shift in monetary policy. Spreads have widened ~200 basis points (bps) YTD (peaking around 300 bps wide in July). For investors who have maintained high yield bond exposure throughout 2022, like with prior recessionary periods of high yield bond performance drawdowns and spread widening, we expect high yield bond returns to rebound when inflation prints moderate and U.S. economic growth prospects improve.
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