Don't call it junk

While current valuation measures are on the rich side of historical medians, and now may not be the time for a maximum allocation to high yield, the higher quality breakdown of the market according to the major rating agencies and the current relatively strong financial position of high-yield issuers supports a strategic long-term allocation to the asset class. 

The overall profile of the high-yield bond market has migrated up in quality over the last decade and a half, with the percentage of BB-rated bonds increasing, and CCC-rated bonds decreasing. High-yield bond issuers have benefitted from a strong economy and healthy dose of low coupon fixed-rate bonds in their capital stack. Also, strong demand for yield in what is still a low interest rate environment has prevented credit spreads from moving aggressively higher. While high-yield spreads (the difference in yield compared to similar maturity U.S. Treasuries) are currently on the rich side (347 basis points as of July 2024 compared to the long-term median of 492 basis points since 1982), we don’t believe spikes in spreads amid periods of potential economic weakness are likely to reach the same levels they have reached in prior cycles. For example, they have often exceeded 1,000 basis points in prior periods of market stress. 

Floating-rate issuers have been challenged

Conversely, the quality profile of leveraged bank loans has moved lower. Over the past decade-plus of historically low rates, riskier issuers were drawn to the bank loan and private credit markets, given lower costs as base rates hovered near zero (Libor until it was functionally replaced by SOFR this decade) and the attractiveness of limited call protection. 

Due to the dramatic move higher in rates over the past two years, floating-rate loan issuers face more immediate cash flow challenges to manage higher interest cost. In many cases, interest expense has more than doubled, interest coverage ratios have fallen dramatically and downgrades have overwhelmed upgrades. Also, given the lack of unsecured bonds in the capital structure to absorb credit losses, recovery rates on loan only capital structures have fallen. 

Manageable maturities

Recently, there has been some concern around high yield debt that will be maturing over the next few years. However, the strong market so far in 2024 has allowed many issuers to come to market to term out near term maturities and with yield spreads approaching historically tight levels, the all in cost of these debt refinancing, while somewhat higher, have not been punitive. Many of the companies that have debt maturing over the next few years are higher in quality relative to the overall market and we believe will not have difficulty refinancing this debt. Also, high-yield companies have typically been proactive in managing debt maturities often refinancing debt between 1 to 3 years prior to maturity helping to alleviate concerns around the much feared “maturity wall.”

Portfolio diversification

Historically, high-yield bonds have exhibited higher correlation to equity markets given their sensitivity to the business cycle, and lower correlation to high quality bonds, providing potential for attractive diversification benefits. The higher coupon income demanded by investors as compensation for higher default risk has helped dampen the volatility that bonds can experience in periods of rising interest rates, often outperforming higher-quality bonds with lower coupons and longer durations.

We believe high-yield companies are in a relatively strong position to manage through refinancing at higher rates following the historic Fed action in recent years, particularly those in less cyclical industries with stable cash flow.