Wednesday, July 26, 2023
The high yield corporate credit market (Bloomberg U.S. Corporate High Yield Index) has been extremely resilient this year outperforming high quality fixed income (as proxied by the Bloomberg Aggregate Bond Index) by over 4%. Macro headwinds, such as 5% of interest rate hikes, debt ceiling debates, and regional banking stresses have (so far) all proved to be no match for the allure of high yields. But we think investors should exercise caution if investing in the high yield markets.
We commonly talk about how fixed income instruments are fundamentally different than other financial instruments because they are financial obligations that are contractually obligated to pay periodic coupons and return principal at or near par at the maturity of the bond. So, absent defaults, there is a certainty with bonds that you don’t get from many other financial instruments. And because starting yields take into consideration the underlying price of the bond as well as the required coupon payments, starting yields are the best predictor of future returns. However, leveraged credit (high yield bonds and leveraged loans) does experience defaults that eat away at potential returns.
And defaults have started to pick up. A monthly average of $8.7 billion of bonds/loans have been affected by default/distressed exchange activity in 2023 versus $2.6 billion across 2021/22 and $4.1 billion post-Global Financial Crisis (2010-today). Including distressed exchanges, the par-weighted U.S. high-yield default rate is 2.71%, which is up from the 1.65% rate to start the year, and is expected to increase from current levels. With defaults expected to continue at an elevated pace, starting yields may not actually be reflective of expected returns. Per analysis by Bloomberg Intelligence, the 1999-2002 cycle could be instructive for those eyeing the 8%-plus yields today. Average returns over the four-year window were negligible, despite beginning yields-to-worst for the Bloomberg U.S. Corporate High Yield Bond Index of 10.5%, 11.5%, 14.5% and 12.5%. The cumulative total return over that period: 0.05%. That’s a lot of risk for very little return.
One of the great things about fixed income is you don’t have to take risk if you’re not being compensated for it. Most portfolios have an equity allocation and there is where you generally take your risk. So, while it’s true that yields for high yield bonds are above longer term averages, the additional compensation for owning fixed income risk isn’t great, in our opinion. So, given the still uncertain macro environment, we prefer an up-in-quality approach within our fixed income allocations.
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