A systematic approach to high yield credit

Overview

The asymmetric return profile of high yield bonds steers most portfolio managers toward positioning for downside risk rather than upside potential. This encourages high yield managers to build defensive portfolios irrespective of the macroeconomic regime. In this research, we investigate why (even top quartile) managers in high yield may not be fully positioned to capture the rebounding nature of this asset class, and offer a systematic counter perspective to this traditional approach.

Does good defense in credit markets mean giving up offense?

A strong fourth quarter in 2023 capped a year of broad positive returns across asset classes. The S&P 500 gained over 26%, US high yield rose 13%, and the Bloomberg US Aggregate Bond Index gained more than 5%, a sharp reversal from 2022’s widespread declines. From 2022–2023, investors navigated attractive all-in yields but tight spreads, underscoring the need for selectivity in corporate credit.

The asymmetric return profile of high yield bonds often drives managers to focus on limiting downside rather than chasing upside potential. Between 2005-2025, eVestment data show most high yield managers maintained defensive portfolios — capturing roughly 89.56% of down markets and 92.24% of up markets — suggesting they often sacrificed participation in “up” market regimes in favor of downside protection.

Using the returns of the ICE BofA High Yield Constrained Index from June 2005 through June 2025, we found that US high yield markets generally oscillate between four monthly performance regimes. We defined these four regimes as <1.5% (“Very Negative”), >=-1.5%<0% (“Negative”), >=0 - <1.5% (“Positive”), and >1.5% (“Very Positive”). We saw that high yield managers deliver the bulk of their excess returns in “Very Negative” regimes, and trailed index performance in “Very Positive” regimes (see Figure 2). When accounting for the average management fee of active high yield managers, net of fees excess returns would be negative in all regimes except “Very Negative” regimes. The total of “Positive” and “Very Positive” regimes (168 months) vastly outnumber the total of “Negative” and “Very Negative” regimes (72 months), emphasizing the importance of delivering upside participation in addition to downside mitigation over the long run.

A review of periods of market stress (in Figure 3), including the 2013 taper tantrum, 2018 tightening of financial conditions, 2020 COVID drawdown and spread widening in 2022, we can observe the defensive dynamic among both average and top quartile active managers. Importantly however, in the months where rapid transitions between “Very Negative” and “Very Positive” performance regimes occurred, the same group of managers were unable to capture upside as the broader market snapped back. In many cases, these managers gave up more excess return in subsequent “Very Positive” regimes than was mitigated on the downside during “Very Negative” regimes. In today’s environment, as market drawdowns have commonly been followed by quick rebounds, employing a defensive strategy that relies on beta tilts alone may lead to underperformance in a market rebound as shown in Figure 3.

The science of security selection

We believe the best outcomes in credit markets are possible through improved security selection rather than beta tilts. A strategy that is flexible enough aiming to balance downside mitigation and still participate in strong market regimes is imperative to help investors navigate today’s markets. An uncertain economic outlook, increased volatility in asset pricing and sharp asset class reversals demand a strategy that can adapt to counter market reactions or further shifts in monetary policy.

Our high yield strategies are built on the foundation of a quality screen, which aims to mitigate losses in a portfolio during periods of market decline. Using our proprietary probability of default signal, we screen out the names with the highest default probability. In a portfolio where you are solely screening for higher quality bonds, you could achieve a defensive outcome, but also lower overall total return as analyzed in the full report. Intuitively, reducing default risk results in a higher quality portfolio, but that also comes at the expense of total return.

To counterbalance our quality screen, we seek to evaluate credit value at the same time. We identify bonds that have compelling default-adjusted spread, meaning bonds with a wider spread, adjusted for the default risk the investor is taking on. Combining these insights may lead to higher Sharpe Ratios and higher returns than the overall high yield market.

Systematically navigating credit risk

Investors who rely on high yield bonds to generate incremental return understand that periods of market stress can result in increases in downside risk. Most high yield strategies prioritize mitigating this risk, as indicated in Figure 1. But there are potential solutions to manage downside risk, along with seeking to maximize upside return potential. A systematic approach benefits from the opportunity to cover thousands of high yield issuers daily. Unlike fundamental managers, systematic financial models are less susceptible to bias in the investment process. Our models employ strict criteria to identify entry and exit points on securities. This approach seeks to lessen the risk of emotions playing a role in closing winning positions too early or holding onto losing positions too long.

A systematic investment approach to credit also prioritizes an ability to embed defensive positioning that may help protect investors when they need it most, during down market environments. Our proprietary probability of default signal that has underpinned all of our credit strategies for over 20 years has successfully identified 74% of the defaulted bonds in the ICE BofA High Yield Index within 24 months of its default since 2010.⁶ Our probability of default signal centers on a simple economic assumption that default occurs when the value of a firm’s assets fall below the value of its liabilities. The probability of default model uses accounting, market data of equity and bond instruments, bond ratings, and other economic variables to estimate the probability of default for the issuer over a forward looking 12-month period. A full balance sheet approach is taken in assessing credit quality, not dissimilar to fundamental credit analysis to evaluate risk. We believe defensive outcomes are key to integrate in credit strategies to counter the asymmetrical nature of credit markets.

The science of security selection

Unlike many high yield managers, we don’t believe that upside should be sacrificed at the expense of downside mitigation. We believe the best outcomes in credit markets are possible through improved security selection rather than beta tilts. Despite the unfavorable asymmetry of risk and return in credit markets, it is not always prudent to be looking for safety, irrespective of the macro-economic environment. A strategy that is flexible enough to balance downside mitigation and still participate in strong market regimes is imperative to help investors navigate today’s markets. An uncertain economic outlook, increased volatility in asset pricing and sharp asset class reversals demand a strategy that offers flexibility to counter market reactions to further shifts in monetary policy.

Our high yield strategies are built on the foundation of a quality screen, which can help mitigate losses in a portfolio during periods of market decline. Using our proprietary probability of default signal, we screen out the names with the highest default probability. In a portfolio where you are solely screening for higher quality bonds, you would achieve a defensive outcome, but also lower overall total return as analyzed further in the full report. Intuitively, reducing default risk results in a higher quality portfolio, but that also comes at the expense of total return.

To counterbalance our quality screen, we seek to evaluate credit value at the same time. We identify bonds that have compelling default-adjusted spread, meaning those that you are being compensated with a wider spread, adjusted for the default risk you’re being asked to take. Combining these insights can leads to higher Sharpe Ratio as well as higher return than the overall high yield market.

While this approach is not overly complex, the daily application of our proprietary systematic default signal insights to the high yield universe, alongside a disciplined combination of both quality and value insights, is what can help potentially achieve a better optimized risk and return trade-off. Simultaneously, as default risk declines, investors’ search for yield may prove beneficial. Quality screens may help protect high yield investors on the downside, while adding value screens may help improve upside participation.

Seeking to capture alpha opportunity in high yield

Across high yield and investment grade credit approaches, a combination of credit model signals help us align risk characteristics to seek portfolios that exclude any unintended sector, ratings, or duration deviation from relevant benchmarks. Our portfolio construction framework has evolved over decades, and is enriched by signals that seek to capitalize on the inherent biases in credit markets. Our systematic approach to high yield credit markets allows us to have a view on thousands of bond issuers daily.

We believe the best outcomes in credit markets are possible through improved security selection that aims to mitigate downside risk and is well positioned to capitalize on market rotation. Our financial models employ strict criteria to identify entry and exit points on each security -- which means anticipating and countering the impact of monetary policy, geopolitical headwinds or pinpointing the next recession is already built into the framework that underpins each of our systematic credit strategies. We believe investors should be able to systematically capture upside opportunities in the high yield segment of credit markets, without losing sleep over fears of downside risk in their portfolio.

Seeking to capture alpha opportunity in high yield

Across high yield and investment grade credit approaches, a combination of credit model signals help us align risk characteristics to help ensure our portfolios exclude any unintended sector, ratings, or duration deviation from relevant benchmarks. Our portfolio construction framework has evolved over decades, is enhanced by our systematic expertise, and enriched by signals that seek to capitalize on the inherent biases in credit markets. Our systematic approach to high yield credit markets allows us to have a view on thousands of bond issuers daily.

We believe the best outcomes in credit markets are possible through improved security selection that helps mitigate downside risk and is well positioned to capitalize on market rotation. Our financial models employ strict criteria to identify entry and exit points on each security, which means anticipating and countering the impact of monetary policy, geopolitical headwinds or pinpointing the next recession is already built into the framework that underpins each of our systematic credit strategies. We believe investors should be able to systematically capture upside opportunities in the high yield segment of credit markets, without losing sleep over fears of downside risk in their portfolio.