High Yield: Strong Performance, But Uncertainty Remains

On the heels of strong Q2 performance, global high yield bonds and loans continue to provide attractive risk-adjusted return opportunities for investors—particularly those with the flexibility to look beyond the traditional indexes.

Highlights

High Yield Bonds Outperform: High yield performance was broadly positive during the second quarter, even as a number of global risk factors threatened to introduce volatility into the markets. Combined with strong first-quarter performance, bonds and loans in both the U.S. and Europe delivered positive returns in the first half of the year. U.S. high yield bonds outperformed amid dovish central bank sentiment—returning 10.01% in the first half of the year—followed by European bonds (7.45%), U.S. loans (5.42%) and European loans (2.70%).¹ Even with the strong year-to-date performance, credit spreads remained wide relative to where they were nine months ago and, in our view, are compensating investors for a higher level of defaults than what corporate fundamentals currently suggest.

¹ Sources: Bank of America Merrill Lynch; Credit Suisse. U.S. market returns provided in U.S. dollars and European market returns provided hedged to euros. 

Outlook

• Credit Cycle Remains Top-of-Mind: As we move through the late stages of an elongated credit cycle, there are questions surrounding the creditworthiness of high yield issuers, and specifically, the likelihood of an increase in defaults. In our view, corporate fundamentals overall remain relatively healthy. Growth appears to be slowing but measured, and we believe most companies have capital structures in place that can withstand and adjust to a slowdown. Defaults are stable in the current market, and we don’t expect to see a material or widespread increase in the near-term. That said, there are certain sectors that certainly require close attention—energy, retail and health care, for example.
• From Loans to Bonds: Interest rate expectations have gone down materially this year, which has contributed to a shift in investor sentiment. When interest rates were rising, retail investors flocked to loans—in the last six months, we’ve seen the reverse happen, as increasingly dovish central bank sentiment has buoyed demand for fixed rate assets. The outflows from loan retail funds have helped keep spreads wide relative to nine months ago without a material change in the fundamental backdrop. We believe loans remain attractive, particularly given their historically lower volatility and higher position in the capital structure. 
• Opportunities Beyond the Index: In addition to the opportunities we continue to see across the traditional high yield loan and bond markets, we also see value in investing opportunistically in non-traditional segments of the market, such as distressed debt/special situations, collateralized loan obligations (CLOs) and emerging markets debt. These markets don’t function exactly the same way as the traditional high yield markets, and they’re not represented in the indexes—but for managers with the right expertise, opportunities can and do arise. As we mention in our recent podcast, many investors have started to think more strategically about their allocations. Rather than trying to time the asset class, the question has become when and where to overweight/underweight as we move through the credit cycle. A flexible or opportunistic strategy can grant access to a larger universe of potential opportunities, while also giving managers the flexibility to pivot to those areas that offer attractive value at any given time.

¹ Credit Spread for bonds represented by OAS and for loans represented by the 3-year discount margin. Sources: ICE Bank of America / Merrill Lynch and Credit Suisse.
² Source: Credit Suisse.