Finding Opportunities Amidst Volatility in High Yield

Aug 23, 2022
  • Dylan Bass
  • Jake Delaney
  • Katie Conry

Using history as a guide, there could be meaningful total return opportunity today with HY market yields at ~7.5%1

Market Backdrop

Despite being down -8.28% YTD, high yield bonds remain ahead of longer duration assets (US IG -11.43% YTD) and equities (S&P 500 -12.58% YTD).1 Risk markets rallied over the month of July as the market eased on concerns about slowing growth and the likelihood of steep rate hikes. High yield returned 5.90%, outperforming both loans and investment grade bonds, which returned 2.14% and 3.24% respectively.

Going forward, slowing economic growth and structurally higher interest rates will undoubtedly impact the issuer base, and therefore we anticipate higher return dispersion across sectors and issuers. From a fundamental perspective, however, backward-looking datapoints such as interest coverage and leverage have been at particularly strong levels. Additionally, due to the record levels of refinancing we saw during 2021, debt costs were pushed materially lower for leveraged finance issuers, and the lack of a near-term maturity wall that resulted is a major factor in assessing HY expected defaults.

With this mixed backdrop in mind, we anticipate default rates to remain below historical averages for the balance of 2022 and into 2023. High yield fundamentals and a positive pivot in technicals will anchor this view.

Breakdown of the opportunity in HY

As investors become more comfortable with the macroeconomic backdrop and look to redeploy risk in discounted markets, we believe high yield presents a compelling opportunity to enhance risk-adjusted returns. Using history and actual results a guide, we ran a ratings-adjusted analysis of 12-month forward returns given starting yield buckets of the HY market. This broke down each week since 2010 by the market’s yield to worst, as gauged by a ratings-adjusted benchmark of the Barclays Ba, B, and Caa Indices. We believe this more accurately represents the ratings breakdown in the HY market than the broader Bloomberg US Corporate HY Index.

Notably, all of the 134 weeks since 2010 with starting yields of >7% showed positive returns. When the Bloomberg US Corporate HY Index is yielding greater than 7%1, the median 12-month forward return has been 13.2% since 2010. Even if we shorten our measured horizon to 6-months, the historical forward returns remain compelling at yields of >7%, with median returns still delivering ~7%.

Our conclusion

Despite near term macro uncertainties, many investors are looking to opportunistically rebalance portfolios given YTD repricing. While volatility may persist for the remainder of the year, history has shown that environments like the one we are currently in has provided returns into the double digits for this asset class based on a >7% starting market yield.