CONTRIBUTORS
Bill Zox, CFA
Portfolio Manager,
United States
John McClain, CFA
Portfolio Manager
United States
This is an extract from the recently published Year-end outlook: A tipping point.
The high yield market has been in a high carry, or high absolute yield, and low dollar price environment since the middle of 2022. The difficult valuation adjustment for high yield took place in the first half of 2022 when the yield increased from the low 4% range and the dollar price declined from above 100 cents. That dramatic shift in 2022 positioned US high yield to enter 2023 with a yield of about 9% and a dollar price below 90 cents. The valuation metrics for the global high yield market were similar. We believed those metrics were attractive, and we expected long-term returns to be strong from that starting point. Returns have been strong in 2023, and the yield is still about 8.5% while the dollar price remains around 90 cents. The strong high yield returns stand in marked contrast to the returns in core fixed income, which were under pressure until the last two months of 2023 due to rising interest rates and elevated interest rate volatility.
The bear case for high yield has been based on credit spreads, which have been well below the range that tactical allocators have looked for since the early tech-telecom bubble in the early 2000s and the global financial crisis in 2008. Credit spreads have largely been in a range of 400–600 basis points since the middle of 2022. The yield has been more stable while credit spreads have fluctuated more based on Treasury yields and interest rate volatility than on the outlook for default losses, which continues to be contained.
We have maintained that a 400–600 basis points spread range in this cycle is comparable to 600–800 basis points in previous cycles. High yield issuers are now bigger companies, more often publicly listed, with higher credit quality, seniority, and credit ratings. The smaller, more aggressive financings and leveraged buyouts are more often found in the leveraged loan and private credit markets. The management teams of leveraged businesses have, in many cases, been working more for bondholders than stockholders for over a year. And—except for a small percentage of stressed or distressed borrowers—they have had and continue to have access to capital in a variety of markets. The longer dramatic spread widening is delayed, the less likely it becomes if management teams are focusing their capital allocation on deleveraging, debt reduction, and bond buybacks rather than stock buybacks, dividends, and debt-financed mergers and acquisitions.
Finally, as the exhibit below shows, the US high yield market has benefitted from negative net supply for the last two years, and we expect a similar dynamic in 2024 if interest rates remain near these levels. In fact, all of the favorable dynamics that have led to strong high yield returns since the middle of 2022 are still in place for both the US and global high yield markets. While tight monetary policy may become more problematic for the economy over time, many high yield issuers are intensely focused on improving credit quality, which will put them in a better position to withstand an economic downturn.
Exhibit 1: US High Yield Annual Net Supply USD issuance (billions).
As of November 30, 2023
Source: ICE Data Services LLC, BofA Global Research (© 2023).
Definitions:
A basis point is one one-hundredth (1/100, or 0.01) of one percentage point.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.