Guest Post: The Case for Including High-Yield Bonds

A common refrain amongst the investment community is that with central banks moving to cut rates, inflation must be tamed and economic strength is the new concern. In such an environment, it makes sense to move up in quality within corporate bonds because you will be more exposed to bonds that are more interest rate sensitive and less exposed to credit sensitive assets.

We do not disagree with the central premise of this argument. Where we think it falls down is when it is applied simplistically. One could quite easily have assembled a convincing case for an impending recession in the past 24 months – inverted yield curves, weak purchasing manager indices, subdued consumer confidence – and avoided high yield bonds in their entirety. To do so would have been costly as global high yield bonds, represented by the ICE Global High Yield Bond Index, delivered a total return in US dollars of 31.9% over the 24 months to 30 September 2024.¹

High yields offer a head start

Part of that strong return has come from capital gain, but nearly 60% came from income. Time and again, throughout history, it is income that typically drives the long-term returns on assets. Today, US high yield is yielding approximately 7.0% and European high yield 5.8%.² These are not the most generous yields, but they are not mean either and certainly not in the context of current inflation levels. A cursory glance at the yield on US high yield versus US inflation (headline Consumer Price Index) suggests that current yield levels are about standard for the last 20 years outside the spikes that occur in crises.

Spreads tight but could they go tighter?

It is at the credit spread level that valuations on high yield bonds look rich but just because they are at the tighter (or low) end of their range does not mean they cannot go tighter. As a reminder, the credit spread is the difference in yield between a corporate bond and the equivalent government bond. It is essentially the part of a corporate bond’s yield that reflects the additional compensation investors want to be paid to take on the risk of lending to that company. A soft landing is the type of environment that could allow credit spreads to tighten further, since moderate economic growth should allow cashflows to be maintained and reduces the risk that central banks would revert to raising interest rates again.

Spreads widen when investors demand greater compensation to own bonds. Right now, tight spreads are the market’s way of signalling that investors are reasonably comfortable to accept credit risk (the risk that a corporate borrower is unable to meet their debt repayments). This is evident in bond issuance where the supply of corporate bonds has been met by plenty of demand from investors. In the first nine months of 2024, companies have issued €74billion in non-financial high yield bonds in Europe, up 97% on the same period last year, while in the US some US$235 billion has been issued, up 74%.³ Companies can access markets, and this is helping to keep the default rate relatively low considering we have just come through a tightening cycle.

Spread levels can be thought of as compensation for fundamental risk (risk to corporate cash flows coming either from wider economic growth factors or factors unique to that company) and liquidity risk (ability for a company to refinance, typically influenced by supply/demand for bonds and the environment fostered by central banks).

On the fundamental side, we are getting mixed data. US economic data has been resilient but European purchasing manager indices – which indicate business activity levels – have been moribund.

On the liquidity side, on both sides of the Atlantic, interest rates are coming down. In the US, the most recent figures for the US Federal Reserve’s (Fed’s) preferred inflation measure (Personal Consumption Expenditures) was at 2.2% year-on-year for August 2024 at the headline level (2.7% at the core level that excludes volatile food and energy prices).⁴ This is close to the Fed’s 2% inflation target, providing the Fed with flexibility to cut rates aggressively if the economy weakens. The Fed’s 50 basis point interest rate cut in September was proof that the Fed is keen to be pro-active in tackling any economic deterioration. With the rate cutting cycle underway, pressure on interest coverage ratios diminishes.

Within Europe, we are seeing a growing proportion of high yield issuers opting for floating rate notes. These are bonds that come with an interest rate that changes (floats) rather than a fixed coupon. The benefit to the issuer is that the rate should fall as central banks cut policy rates. This would allow for a faster transmission of looser monetary policy, and with the European Central Bank considering bringing forward rate cuts the impact could be felt even earlier.

Positive re-rating

We said at the beginning that high yield bonds are not universally loved. Investors see attractions from the yield but are wary about tight spread levels. Part of this reflects a preference for rate sensitive assets over credit as well as some de-risking ahead of the US election. In our view, this is good. If favouring high yield over investment grade was popular then the asset class would be more vulnerable to sell-offs. As things stand, high yield is in the bucket that asset allocators view with caution.

The same could have been said about Chinese equities until last month. Chinese equities jumped more than 20% in a matter of days in late September in response to stimulus announcements from the Chinese authorities.⁵

Something similar has happened within high yield bonds issued by telecommunication (telco) companies. In the past few weeks we have seen merger and acquisition activity in the telcos market, with Verizon bidding for Frontier Communications – a company that essentially reunites Verizon with some of the fibre network assets it sold back in 2017. The pending deal is positive for Frontier bonds that are expected to be refinanced by Verizon, which has a stronger credit rating. Meanwhile within media, DIRECTV has bid for EchoStar’s video distribution business DISH. Concurrently, AT&T is selling its 70% holding in DIRECTV to release money partly to reinvest in fibre connectivity.

The merger and acquisition activity has the potential to create synergies and reduce costs but we think some of this re-rating can be linked to the theme of artificial intelligence (AI) and the increased need for data transfer. Fibre networks are being revalued as a useful transmission tool. What this means is that a high yield company such as fibre network business Lumen, which over-expanded and over-levered its balance sheet, in our view now has considerable growth potential because it has the hard assets of a global fibre network in place.

Whether it is consolidation or a re-evaluation of assets in a business, we are seeing market sentiment towards telco assets, particularly those with fibre businesses, turn more favourable and that has caused spreads to come down and bond prices to rise as yields have fallen sharply in the sector. Over the course of the third quarter of 2024 alone, the telecoms sector of the US high yield market returned 11%.⁶ Yet yields and spreads remain elevated, which could offer the prospect for further gains.

Due diligence

Taken together, we think the cautious attitude towards high yield may be misplaced and (putting geopolitics aside) the positive run in high yield can continue so long as the US economy holds up. That does not mean being complacent. We need to be mindful that idiosyncratic risk is ever present and high yield bonds are rated lower quality for a reason. Challenges exist. These challenges can and are being dealt with, which explains the relatively low default rates experienced during the most recent tightening cycle.

Yet we also need to recognise that some bonds will struggle. Among bonds rated CCC, the amount of cash available to cover debt costs is low, with many companies actively burning cash. They can cut capital expenditure (capex) to free up cash to some extent, but even this has negative implications as one company’s saving on capex is another company’s lost revenue.

The tightness in spreads means little room for disappointment so earnings results alongside economic data will command particular importance. For now, economic data continues to point to a soft landing and central bank rate cuts should help to bring down bond yields. High yield bonds typically have shorter maturities than investment grade bonds on average, so a decline in the front end of the yield curve has the potential to help boost total returns and cut refinancing costs.

So far, rate cuts have been in response to falling inflation and as a precautionary measure to ward off economic softness. Provided that remains the case, we think high yield continues to offer attractions within a diversified portfolio.