The story of high yield as the asset class to watch was long touted throughout 2023, and its endurance throughout Q1 of this year is telling the larger story of how strong fundamentals, a benign default outlook, and a history of outperforming equities during periods of elevated equity volatility has kept high yield at the front of investor minds.
The fourth quarter of 2023 brought notable shifts in high yield bond markets, yet the asset class is poised to continue to do well through the end of 2024. As higher interest rates have firmly cemented high yield bonds into institutional portfolios, the secret to success moving forward will lie in how investors select their managers, ultimately positioning the research process as what will ultimately determine investor success.
Why High Yield?
Although categorized as a “risk asset”, high-yield bond markets have evolved greatly over the past 15 years to provide investors with both diversification and downside protection in certain markets when equities become richly valued. While having been previously given a wide berth in the early days of the asset class, the high-yield market has grown in size and quality tremendously from a $500 billion market in 2002 to over $1.5 trillion, according to Nasdaq.
Additionally, Debtwire figures show high yield debt issuance has more than doubled from Q2 of 2022 to Q2 of 2023 alone, from $20.8 billion to $50.08 billion. Although bolstered from relatively weak markets in 2022, high yield bond issuance in the United States climbed by 58.4% from $96.5 billion in 2022 to $152.9 billion by the end of 2023, according to White & Case and Debtwire figures. Additionally, in Western and Southern Europe, issuance rose by 47.3% from $53.9 billion in 2022 to $79.4 billion in 2023. As of Q1 2024, global high yield volumes have been somewhat muted in the anticipation of interest rate cuts and a challenging macro environment, but opportunities remain.
In the past high yield was as a necessary allocation to diversify risk or diversify the portfolio overall but was not the yield-producing mainstay it is today. It might have been considered just another tool in the toolbox in the past but has been shot to the forefront versus previous decades because of performance and the expanded universe of high yield offerings as a whole.
There is now a larger and more sophisticated pool of investors that are more open to high yield investments given that the breadth of the credit universe has evolved as such that the asset class has a better underlying credit foundation than it perhaps did during the Global Financial Crisis and the years thereafter.
Why High Yield Now
Current market conditions and favorable returns mean it’s high time for high-yield.
The recent equity rallies in February and March of 2024 suggest some renewed investor confidence in the possibility of a soft landing, which many have implied to mean continued growth, normalized inflation, and less materialized geopolitical consequences.
The Federal Reserve has signaled that progress on inflation has stalled and maintained its position on rates. Investor sentiment has evolved, with markets now pricing in around two rate hikes by the end of the year and with data suggesting inflation proving stickier than expected this might not materialize until September. This puts high yield investments in the driver’s seat for quite some time still.
“Earnings expectations are now following the path of United States growth. Consensus now expects S&P earnings to be up 11% this year. I want to point out that this figure is higher than the 10-year moving average of where earnings have been, and that’s of course coming off a very negative year in 2023, where earnings were down,” says Anwiti Bahuguna, CIO of global asset allocation at Northern Trust Asset Management. “Our internal Northern Trust Asset Management analysts have looked at earnings expectations and their assessment is in fact growth will not only be solid, but it might actually exceed the 11% that the consensus is expecting,” she adds.
“The combination of strong growth and a stall in inflation prints coming down meant the market has been pricing out the expectation of rate cuts. If inflation does not show further signs of falling, we could see a strong resurgence, essentially pricing out the two expected cuts. The growth we then expect might not be enough to balance higher rates. This of course has implications for stock markets and risk assets,” she adds.
Additionally, top Eurozone policy makers have stated that if the United States holds its tight monetary stance for longer, the ECB is likely to need extra interest rate cuts if global borrowing costs remain elevated, meaning rate cuts might happen sooner in European markets than in the United States.
This interesting rate environment comes at a time of the largest universe of high yield bonds available. Moreover, a supportive environment of low default rates and potential (but yet uncertain) volatility for equities signals this is one of the best times to allocate to high yield for investors who are able to take on the risk exposure.
“High yield spreads have exhibited a very low level of volatility on a YTD basis and frankly reside at the tighter end of the spread range over the last couple of years. At the aggregate level, many investors may be curious as to the opportunity set available to them with all-in spreads hovering around 300 basis points. Given the outperformance of the asset class relative to other assets, it is clear that the consistent income generation that it affords is a major influence on investors. Currently the yield to worst is north of 8% and there is a 10-point discount relative to par – both have been overriding factors in investors’ decisions to allocate to the asset class,” says Eric Williams, portfolio manager and head of capital structure, global fixed income at Northern Trust Asset Management.
The asset class is supported as well by strong underlying fundamentals. The high yield market is of higher credit quality today than its 20-year average. The high yield market overall, as of March 31, 2024, is made up of 48% BB-rated bonds, whereas the 20-year average is 43%. The trend continues moving further down the investment-grade scale, consisting of 39% B-rated and 12% CCC-rated bonds in the same time period compared with a 40% and 15% 20-year averages respectively.
Interest coverage ratios also remain strong, hovering between 5-5.75% throughout 2023 and while leverage has ticked up slightly, it remains well below historic peak levels going back to 2011. Another strong indicator of the market’s health, only 12% of the high yield universe currently has debt maturities over the next 2 years from 2024-2025, meaning investors still have the opportunity to capture the asset class’s potential.
Benign Default Outlook
One ongoing concern surrounding high yield is default rates, and even more so now due to the upcoming maturity wall where businesses can expect to refinance in a much higher interest rate environment, causing concern from investors around their ability to absorb this strain. Companies are much better capitalized to cope with restructuring their debt and handling the upcoming maturity wall, and therefore low default rates are expected to continue.
“Despite elevated macro concerns, over the last 1-year period 40% of debt maturing between 2024 and 2026 has been refinanced, which is the most rapid debt extension in history. Treasurers have continued to make tremendous progress pushing out of their maturity profile, which reduces near term risks. In general, markets are open for most companies and as a result, distress remains low and that is a tremendous indicator for the limited prospects for an increased future default rate. As such, we believe spreads will be fairly rangebound amidst reduced volatility,” adds Williams.
Additionally, the distressed ratio – often looked upon as a forward-looking indicator for defaults – has remained well below 2008 and pandemic levels, and fairly stagnant since April 2021.
Given a benign default outlook and that near-term interest rate cuts are now unlikely, yields in the asset class may well stay above the ten-year average through at least the end of 2024.
A New Growth Cycle Spells Opportunity
As markets throughout the world enter a possible period of higher growth, high yield presents itself as a good opportunity for both income and capital appreciation considering current valuations.
“At this time, we continue to favor transportation, finance, and certainly some industries within energy, as these are all sectors that have either de-risked or offer ample risk-adjusted total return opportunities given increased levels of dispersion. Despite the outperformance YTD, certain CCCs remain attractive, and on a historical basis offer spread compression potential relative to some higher rated parts of the market, which is many cases are trading tighter than investment grade companies on a spread basis. Today, CCC’s are trading near their median spread level on a historical lookback, while BBs and B’s are screening quite rich. An active approach to portfolio construction and risk management is optimal for this environment,” says Williams.
Moreover, in Europe, heightened expectations of near-term interest rate cuts caused European government bonds to decline, but this disproportionately benefited BB-rated bonds – the longest-duration assets in the high yield bond market. European high yield bonds remain attractive despite the recent rally, and while the average price in the market rose significantly during the end of last year, it ended 2023 at 91 cents on the dollar – meaning investors still have quite the opportunity for capital appreciation.
Overall, high yield bonds are trading at a meaningful discount to par in the United States and Europe, giving investors compelling opportunities for both capital appreciation while maintaining strong call protection.
“There’s ample opportunity across ratings segments, but it requires a diligent active hand to research as well as portfolio management to uncover the value in these targets,” he adds.
It’s Time to Take A Serious Look At High Yield Managers
A year ago, when rates were climbing, high yield was an easier choice but now as conditions have become more nuanced and macro conditions more perplex, high yield strategies will not be as simple as they were in 2023. Specialized management, that is, managers who specialize in asset selections and evaluating both sides of the capital structure to alienate issuer specific risk, is becoming more paramount to achieve strong risk adjusted returns.
While the current environment lends itself well to high yield investments, strategies tailored to deliver high current income and limit losses during market downturns by identifying relative value opportunities and minimizing defaults will be positioned to outperform. A top down and bottom-up research process, like that conducted by Northern Trust’s capital structure team, focuses on both capital appreciation while avoiding large, concentrated bets.
Their approach toward fundamental credit selection aims to represent the yield vs. credit risk trade-off by recreating the investment universe into cells, for example, sector, rating, and maturity.
Success in this macro environment will hinge on research teams that are able to identify compensated relative value beyond systematic risk, with the goal of achieving a holistic view of risk and ultimately offering clients risk profiles they can both be comfortable with and benefited by.
While interest rates may stay elevated for some time still, differentiating high yield management strategies will be necessary to maintain a competitive advantage.
To find out more about High Yield at Northern Trust, click here
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