High yield: the ugly duckling of the fixed income universe?

The following is an extract from our Q4 Active Insights publication.

No investor would suggest that this small part of the fixed income universe should be on a par with investment-grade swans (high-yield bonds make up just 2%[1] of the universe currently). But, as Andersen himself tried to subtly point out, even ugly ducklings should be given a better reception in life.

And yet high-yield bonds are typically disliked by investors, in our view. Potential default fears, which inevitably gather momentum at the later stages of the economic cycle, are one reason. The permanent association of being inextricably linked with the label of ‘junk bonds,’ or triple C rated debt, another.

Income high-flyers

Undisputedly though, high-yield bonds have long been a source of income for investors, often competing, in the publicly listed arena at least, with both dividend equity income on the one hand, and rental income from property on the other. While all investments can change in value on a mark-to-market basis, equity and property prices don’t always revert to fair value. Bonds, however, have a deadline by which they have to repay at par ... unless of course investors are forced to take a haircut in the event of a default.

For now, default rates for BB and B rated high-yield bonds remain low (see chart on opposite page). Admittedly, this has been a particularly benign global economic cycle, characterised by an era of unprecedentedly low interest rates. But, as the chart below shows, US longer-term defaults are only just normalising, with the one-year rate still low compared to historic standards. Any rise in defaults is invariably concentrated in the triple C part of the market – an area we studiously avoid.

Migrating to Europe

Europe is an economic region characterised by relatively low growth (compared to emerging markets and the Americas). But it enjoys relative political and economic stability. We believe this is a potentially favourable environment for high-yield bonds: the stability keeps defaults contained, while low (but still positive) growth is enough to keep fundamental credit metrics improving.

For investors mindful of defaults, we believe Europe is still top of the pecking order in terms of quality. Two-thirds of the index we follow[2] is BB rated, with the remaining third single B. BB default rates average around 1% annually, against a current yield, in euros, of 8%[3]. Furthermore, we believe there is sufficient protection here from the triple C end of the credit spectrum.

The debate between the merits of public versus private credit has been hotly contested for several years. The latter has soared in popularity – private debt currently sits at US$1.5 trillion[4]. But asset allocations into leveraged loans, direct lending and private credit have taken demand away from the European high-yield space in recent years. We believe this has served to keep the pricing of European high-yield bonds low in relative terms, which represents an attractive entry point, in our view.

Investor implications

The big question for investors right now is how will high yield perform in a higher-for-longer rates environment? As high-yield bonds are a fixed coupon investment and, in aggregate, don’t reach their maturity walls for another three years or so, cash interest costs would take a long time to rise for our universe of issuers under this scenario. The price outcome would be magnified for higher-duration government and investment-grade bonds, in our view, but the greater yield drawn from high-yield bonds, we believe, protects the prices more from a higher rates environment.

The above is an extract from our Q4 Active Insights publication.

[1] Source: ICE-BAML (via Bloomberg) as at 28 September.

[2] Source: ICE BofA BB-B Global High Yield Non-Financial 2% Constrained Total Return Index (Hedged to GBP).

[3] Source: Bloomberg as at 23 October 2023.

[4] Source: Bloomberg as at September 2023.