What Spreads Don’t Tell Us About High Yield

Among some investors, there is the belief that high yield only makes sense when spreads reach certain levels (for example, 700 basis points (bps)). While they are important for investors to consider, spreads shouldn’t be the only consideration. The 20-year median spread is 438 bps, significantly less than 700 bps. In fact, 700 bps is in the 13^th percentile — a level reached only for brief periods of time and relatively infrequently. Now this isn’t to say that wide spreads aren’t a good investment opportunity — on the contrary, high yield has historically performed well following periods of market turmoil and spread widening. However, high yield has generated attractive returns in other spread environments as well. Looking back to 2023, spreads began the year at 479 bps and high yield mutual funds were in net outflows, yet the market returned 13.4%, outperforming the Bloomberg Aggregate Bond Index by over 800 bps. 
 

High Yield Spreads Rarely Reach 700 bps

Source: FactSet 6/28/24. High Yield represented by ICE BofA High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

While the 20-year median spread is 438 bps, the 10-year median is 406 bps, and the 5-Year is even lower at 402 bps. This is because the high yield market has changed over time, both in terms of the size of the market as well as the composition of the issuers. High yield has become higher quality, and over half the market is now rated BB or higher. At the same time, CCCs have become a smaller percentage of the market. The high yield asset class has become increasingly comprised of larger, higher-quality and more public companies. There are a number of well-known S&P 500 companies represented in high yield, such as United Airlines, Royal Caribbean and Hilton. This is relevant because public companies tend to have more transparency and greater financial flexibility. This explains why the median spread has declined over time — due to the higher-quality nature of the asset class, investors do not require the same risk premium.
 

U.S. High Yield Has Trended Toward Higher-Quality, Public Companies

Source: FactSet 6/28/24. High Yield represented by ICE BofA High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

At the end of June 2024, spreads were below 400 bps for the eighth straight month. Credit fundamentals are fairly strong — interest coverage is above long-term averages, and leverage is below, as of June 30. Given favorable credit trends and low defaults expectations, spreads don’t necessarily have to widen without a catalyst. From 2004−2007, spreads remained below 400 bps for almost three years (there was a short period in 2005 where they briefly exceeded 400 bps). Once spreads dipped below 400 bps in early 2017, they didn’t hit 400 bps again until Q4 of 2018 during trade-war rhetoric. Following that flare-up, in which spreads didn’t come close to 700 bps, high yield returned over 14% in 2019.

Spreads Have Historically Remained sub-400 bps for Extended Periods

Source: FactSet, as of 6/30/24. High Yield represented by ICE BofA High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
 

Waiting for an arbitrary spread-level signal may come at a considerable opportunity cost because high yield does not only benefit portfolios when spreads are wide. Other valuation metrics to consider are price and yield. With respect to price, lower dollar prices have led to favorable outcomes historically. The chart below shows median two-year forward returns bucketed by starting price. Discounted bonds benefit from “pull to par,” or the propensity for bond prices to accrete to par over time. Since high yield has a relatively short average maturity, that “pull to par” happens more quickly than longer-duration asset classes.
 

Discounted High Yield Bond Prices Have Benefited from “Pull to Par”

Source: FactSet 6/30/03−6/30/24. High Yield represented by ICE BofA High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
 

Perhaps the best predictor of high yield returns is the yield-to-worst. Our research shows that over the past 20 years, there is a strong correlation (93%) between the initial yield of high yield and five-year forward returns. As of 6/30, the asset class’s yield-to-worst is just under 8%, compared with the post-GFC (Global Financial Crisis) median of 6.5%.
 

Initial Yield Is Highly Correlated with Five-Year Forward Returns

Source: FactSet 04/30/04 − 05/31/24. High Yield represented by ICE BofA US High Yield Index. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
 

Given current market conditions, we believe it is more likely that any spread widening will be manageable, rather than the degree seen in crises periods. This is noteworthy because the all-in yield has two components — the U.S. Treasury yield and the spread. Typically, spread widening coincides with declining Treasury rates. With Treasury yields being the highest they have been since the crisis, there is more room for them to fall. If spreads widen by 50-100 bps, Treasury yields can fall by that same amount, resulting in no change to high yield bond yields and therefore bond prices. The bond price is dependent upon the yield, and the make-up of that yield with respect to U.S. Treasury rates and spreads is irrelevant.

Continuing to look at the high yield market through a starting-yield lens, we analyzed the dispersion of one-year returns, given starting yields between 7%-9% going back 25 years. In close to half the subsequent one-year periods, the market return exceeded 10%. Over 75% of the time, returns surpassed 5%. Losses occurred in just 11% of the observations, most of which were during the financial crisis.
 

Distribution of One-Year Returns, Given a Starting Yield Between 7-9%

Source: FactSet 6/30/99 – 6/30/24. High Yield represented by ICE BofA 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 the last 20 years, high yield spreads have reached 700 bps four times, and 1000 bps twice. During 2020, that window of a 1000-bp spread lasted mere days. For investors with an appropriate risk tolerance, those were opportunities to capitalize on spread compression and earn outsized rates of return. However, it would be hard to make the case that these were the only times high yield offered attractive relative value. Spreads are certainly an important measure that fixed-income investors should pay attention to, but using this as a binary indicator triggered only by reaching an infrequent level may be doing a disservice to portfolios. High yield generates high current income and acts as a diversifier due to its low correlation to traditional fixed income. Decisions on portfolio allocations should be based on a myriad of data points, including bond prices, yields, and spread levels. Relying on spreads alone can keep investors on the sidelines and miss out on an otherwise appealing opportunity. 

About Risk

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. High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.

Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.

Opinions expressed herein are current opinions as of the date appearing in this material only. Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal or volatility of returns. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors, and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits.

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. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

Definitions

The ICE BofA US High Yield Index racks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.

The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate, taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities.

Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed-income portfolio's price to changes in interest rates.

The global financial crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.