It’s clear that the changed interest rate dynamic marks a major change in the financial conditions that prevailed during the previous decade. In turn, we believe this makes it essential to think unconventionally in making high yield allocations.
Figure 1: Selected Developed Market Long Term Return Assumptions
High Yield Attractively Positioned
Risk averse investors are often willing to give up potential returns when there are lingering fears of an economic slowdown, which would sap corporate earnings and push up equity price volatility. However, the shift in fixed income markets suggests that the return differential between high yield and equities is minimal, but with the former offering potentially less risk. We believe this could be an opportunity for high yield investors to reap equity like returns, while lowering their portfolio’s risk profile.
Today high yield bonds trade at spread levels in line with historical averages, provide a yield above 8%, and according to some projections may offer a 10-year expected annualized return of over 6%. This is highly competitive with the long return expectations for equities, albeit with the possibility of considerably less volatility.1
The High Yield Market Today
Changes in recent years have driven structural improvements in the high yield market. The cumulative effect of these shifts has made the market more conducive to investors, particularly more risk averse ones.
It is significant that companies represented in the high yield market in 2023 tend to be of higher financial quality than in previous economic downturns. As of the end of 2022, the ICE BofA US High Yield Index consisted of 50% BB-rated bonds up from 43% in 2011. Meanwhile, the proportion of CCC-rated bonds has decreased to 12% (see Figure 2 on the next page). This shift can be attributed to generally higher quality issuance, fallen angels and smaller private companies moving to other areas of leveraged credit.
Figure 2: Percent Par Value Inice Bofa Us High Yield Index
One reason for this more encouraging backdrop is the increased presence of public companies, with around 69% of the US high yield market having publicly traded equity. In general, public companies provide more financial transparency which means that investors and analysts can be informed.
Attracting Strategic Investors
Another change is apparent in the growing numbers of strategic and long-term investors in the high yield sector. This has resulted in greater stability. The investor base has become more diverse and less leveraged to include pension funds and insurance companies as well as institutional buyers from outside of the United States.2
All of this has helped to mould the market’s increasingly improved issuer profile. Further stability is also coming from the reduced capital flowing into high yield, leading to a market with better quality and less exuberance. (source: Bloomberg)
High yield offers investors an asymmetric return profile combining upside potential with downside risk. Nevertheless, compared with equities, high yield’s downside risk can be less extreme. Just as stock picking determines the returns of an active equity strategy, skill at individual credit selection is crucial to avoid high yield losses and, in the worst-case scenario, bankruptcies.
In a regime change environment where rates are higher, credit selection will tend to drive return dispersion. This has been particularly the case with the shift in the market from liquidity driving performance to one where underlying company fundamentals are the primary performance driver. The changed market dynamics, driven by higher rates and reduced liquidity, have correspondingly increased the importance of security selection. We believe this boils down to avoiding losers and picking winners.
Long-Term Allocation Strategy
A key component of high yield’s attraction is the 8.5% yields currently on offer, which is around 1.5% higher than their 20-year average. This means that the asset class can generate returns for a portfolio, while providing diversification from equities. High yield thus has the potential to match equities returns, while outperforming them in volatile or down markets.
Typically, investors have looked at high yield as a tactical allocation. From a relative value perspective, US high yield has historically outperformed US equities in subsequent one-year periods when the spread between the two is 3.5% or higher (see Figure 3 below).
Overall, the current heightened value the market is offering makes it an ideal time to consider long-term strategic allocations. High yield also provides potentially better risk-adjusted prospects than fixed income sub-strategies such as private credit and leveraged loans which are more heavily exposed to smaller companies in just a few sectors like technology and healthcare.
Figure 3: Us High Yield Subsequent 1-Year Performance When Thespread Is 3.5% Or Higher
We believe there are solid merits to the case for the value in high yield and employing active security selection to unlock it. Such an approach is predicated on understanding individual companies and sectors to build a diverse, all-weather portfolio of high yield credits. Applying this strategy in a consistent, fundamentally focused fashion makes it possible to mitigate downside risk, while taking advantage of attractive entry points in the market.
The current market juncture may offer institutional investors a valuable opportunity to shift higher volatility equity exposure to high yield at a time when returns are expected to be similar but with less risk. Another benefit beyond the attractive yields available is that this is a shorter duration asset class than private credit. What’s more, high yield issues are often more liquid than loans and offer more transparency.
The paradigm shift in fixed income markets underscores a fundamentally different financial environment and highlights the need for unconventional thinking in market analysis, security selection and portfolio construction. We encourage investors to consider this opportunity in consultation with their investment partners.
1. Source: JP Morgan Asset Management
2. Source: JP Morgan
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
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CREDIT RATING DISCLOSURES (FOR INDEX)
ICE BA Credit Ratings
ICE BA utilizes its own composite scale, similar to those of Moody’s, S&P and Fitch, when publishing a composite rating on an index constituent (eg. BBB3, BBB2, BBB1). Index constituent composite ratings are the simple averages of numerical equivalent values of the ratings from Moody’s, S&P and Fitch. If only two of the designated agencies rate a bond, the composite rating is based on an average of the two. Likewise, if only one of the designated agencies rates a bond, the composite rating is based on that one rating.
A fallen angel refers to a bond which was originally issued with an investment-grade rating but, has since been downgraded to non-investment grade, or high yield status due to the weakening financial condition of the issuing company.
Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting.
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COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
The following indices may be referred to in this document:
ICE BOFA US HIGH YIELD INDEX
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. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million. In addition, qualifying securities must have risk exposure to countries that are members of the FX-G10, Western Europe or territories of the U.S. and Western Europe. The FX-G10 includes all Euro members, the U.S., Japan, the U.K., Canada, Australia, New Zealand, Switzerland, Norway and Sweden. Original issue zero coupon bonds, 144a securities (both with and without registration rights), and pay-in-kind securities (including toggle notes) are included in the index. Callable perpetual securities are included provided they are at least one year from the first call date. Fixed-to floating rate securities are included provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities (“cocos”) are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those issues that potentially convert into preference shares, those with both cumulative and non-cumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Securities issued or marketed primarily to retail investors, equity-linked securities, securities in legal default, hybrid securitized corporates, Eurodollar bonds (USD securities not issued in the U.S. domestic market), taxable and tax-exempt U.S. municipal securities and DRD-eligible securities are excluded from the index. Index constituents are market capitalization weighted. Accrued interest is calculated assuming next-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the index.
S&P 500 INDEX
Standard and Poor's 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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