Source: FactSet 2/28/03 - 2/28/23. High Yield represented by ICE BofA U.S. High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
In fixed income, the opposite of looking at the market through a price lens is a yield lens. The yield-to-worst of high yield has remained in the 8%-9% range this year. Historically, 70% of the time when the market yield was in this range, the subsequent one-year return was greater than 10%. Another 19% of the time, the return was between 5% and 10%. Further, the market was positive in 90% of those one-year periods. A bond’s yield is its theoretical annualized return if bought at a given price and held until maturity. In practice, returns can be greater if a bond’s price appreciates to par before its maturity. Conversely, if a bond defaults, it will not realize that yield. However, since long-term default rates are in the 3.0%-3.50% range, elevated yields have proved to be attractive entry points into the asset class.
Figure 2: Higher starting yields have led to favorable outcomes
Source: FactSet, as of 6/30/23. High yield represented by ICE BofA U.S. High Yield Index; High Yield Energy represented by ICE BofA U.S. High Yield Energy Index The option-adjusted spread (OAS) is the measurement of the spread of a fixed income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Given those fundamentals, it should not come as a surprise that the Energy sector is higher quality than the overall market. Energy has almost 59% in BBs compared with 49% for the market and less than half of the market’s CCC weighting. Perhaps the best predictor of defaults is level of distress. 8.4% of the high-yield market has an average spread of over 800 bps, whereas only 1.4% of Energy has a spread wider than 800 bps.
Figure 7: Wider energy spreads have historically preceded market spread widening
Source: FactSet 7/12/13-7/12/23. High yield represented by ICE BofA U.S. High Yield Index; High Yield Energy represented by ICE BofA U.S. High Yield Energy Index Spread represented by option adjusted spread (OAS). Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
This matters not only because Energy is the largest sector in the market, but also because recent spread widening periods have been led by Energy. Energy spreads have typically been wider than the market, but this trend has reversed in the last year, and Energy is now approximately 80 bps tighter than the market. Even before COVID-19 when market spreads were in the 300s, Energy spreads surpassed 700 bps. For these reasons, it is less likely that Energy will drive market spreads wider in the near to medium term.
So high yield appears to be in a good place — the market is comprised of higher quality; mostly public companies and fundamentals are on solid footing. Energy issuers are well positioned given the strength of their balance sheets. At the same time, prices are at levels typically observed in crises due to rate moves, which could potentially limit further price depreciation. Therefore, spreads very well may remain resilient and not reach levels seen in prior credit events. With prices still at an attractive discount and issuer fundamentals demonstrating resiliency, the high yield fallacy of high yield and spreads could chase investors away from an otherwise appealing opportunity.
Fallen Angel is a bond that was initially given an investment-grade rating but has since been reduced to junk bond status.
ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar-denominated, below-investment-grade corporate debt publicly issued in the U.S. domestic market.
ICE BofA High Yield Energy Index tracks the performance of high-yield bonds issued by companies operating in the energy sector.
Rising Star is a bond that is rated as a junk bond but could become investment grade because of improvements in the issuing company’s credit quality.
Yield to worst is computed by using the lower of either the yield to maturity or the yield to call on every possible call date.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Investing in below-investment-grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. These securities can also be subject to greater price volatility.
This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
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