Public Fixed Income

High Yield: A Compelling Risk-Reward Picture for Long-term Investors

January 2023 – 3 min read

Markets will likely remain on edge in anticipation of a central bank policy pivot, but high yield continues to present compelling total return opportunities for investors willing to ride out the volatility.

The elusive central bank policy pivot is the latest factor, in a long list, adding uncertainty to financial markets. Indeed, while markets rallied late last year in response to better-than-expected U.S. CPI data—suggesting moderating inflation could lead to a less hawkish policy pivot—the momentum quickly came to a halt as the U.S. Federal Reserve indicated further rate hikes are still very much in the cards. The European Central Bank, too, has maintained a more hawkish stance than expected.

While a policy pivot seems unlikely in the near term given that inflation remains near decade-high levels—even if it is moderating—the uncertainty will likely drive further volatility across markets going forward. That said, for investors willing to ride out the volatility and take a long-term approach, high yield bonds and loans continue to present compelling total return opportunities.

Earnings in Focus

If 2022 was the year of interest rate volatility, corporate earnings will likely take center stage in 2023. As inflation climbed last year, many companies maintained enough pricing power to pass higher costs through to their customers; earnings, as a result, remained more durable than some market participants were expecting. Looking across the high yield universe today, the picture seems to be darkening. For one, the lagging effect of 2022’s rate hikes has started to stress parts of the economy and is beginning to impact aggregate demand. Compounded by still-elevated labor costs, the ability of companies to pass through higher prices is starting to deteriorate, which will likely lead to some contraction in earnings going forward—and in some cases, potentially significant misses in headline earnings, which could drive volatility higher.

The technical picture has also remained challenging for high yield, particular loans, against a backdrop of more challenging liquidity and retail outflows in the U.S. Compounding this, there has been a continued lack of new collateralized loan obligation (CLO) issuance, which has historically accounted for a large portion of loan demand.

On the positive side, most high yield issuers still have the flexibility to continue to service their debt through a period of economic weakness, and remain in a stronger financial position today than they would have been before the pandemic. For instance, corporate leverage across U.S. high yield companies fell to 3.4x in the third quarter, which is the lowest level since the fourth quarter of 2019, while leverage across European companies fell to 5.2x in the second quarter.1 At the same time, the credit quality of the high yield market has improved considerably over the past 15 years—BB issuers comprise 53% of the market, while single-B companies make up 38% (Figure 1).

Figure 1: A Higher-quality High Yield Market

hy-compelling-risk-chart1.jpgSource: Bank of America. As of December 31, 2022.

Attractive Total Return Potential

While the difficult macroeconomic environment is unlikely to fade anytime soon, it is also worth noting that mild recessions have not necessarily been bad environments for high yield markets in the past. Investors who stayed invested in high yield through periods of volatility, and even economic decline, have historically been rewarded with attractive, long-term returns. This is partly because high yield, unlike equities, does not require strong economic growth to perform well. Rather, what matters more in high yield is an issuer’s ability to continue to meet the interest payments on its outstanding debt obligations. Slow GDP growth, or even a short period of mildly negative growth, is unlikely to drive significant increase in defaults—particularly across a higher-quality market with solid underlying fundamentals.

In the event of a recession, the potential downside in credit is also likely to be more limited given how challenging 2022 was for most financial markets. While spreads would likely experience some widening from current levels, we do not expect material widening to the extent that total returns would turn negative. This is partly a result of the combination of higher yields in response to rising rates, and materially discounted prices. For instance, high-quality BB bonds in the U.S. and Europe have traded at a discount to par, at roughly 89 and 87, respectively, with an average duration of slightly less than four years—and are currently yielding 6.5%–7.5%.2 At these levels, spreads would need to widen far beyond where they are today—to levels comparable to the sovereign debt crisis and Eurozone collapse—for total returns to turn negative. And again, given the higher quality of the market and solid fundamental backdrop, we believe such an extreme scenario is unlikely.

Figure 2: Average High Yield Index Price Versus History

hy-compelling-risk-chart2.jpgSource: Bank of America. As of December 31, 2022.

We also hold a slight bias for credits in the U.S. market versus Europe. From the ongoing war in Ukraine to the softness in the housing market, risks are more elevated in Europe than in the U.S., which could result in a greater impact on consumer sentiment and spending and therefore a more severe or prolonged recession.

Focusing on the Long Term

Looking ahead, a potential recession, ongoing inflationary pressures, hawkish central banks policy and earnings volatility will certainly remain front and center. In this environment, and with markets likely to remain volatile in the coming months, investors do not need to take on excessive risk to earn potentially attractive returns. In higher-rated parts of the bond and loan universe, as well as in certain parts of the CLO market, the risk-reward picture remains compelling. However, a credit-intensive approach is crucial—to not only avoiding additional downside, but also identifying issuers that can withstand today’s headwinds.

1. Source: J.P. Morgan. U.S. data as of September 30, 2022; European data as of June 30, 2022.
2. Source: Bank of America. As of December 31, 2022.

23-2681051

Adrienne Butler

Co-Head of U.S. High Yield

Scott Roth, CFA

Co-Head of U.S. High Yield

Chris Sawyer

Head of European High Yield

Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Any investment results, portfolio compositions and or examples set forth in this material are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this material No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments. Prospective investors should read the offering documents, if applicable, for the details and specific risk factors of any Fund/Strategy discussed in this material.

Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).

NO OFFER: The material is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This material is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy, and must not be construed as a projection or prediction.

Unless otherwise mentioned, the views contained in this material are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Individual portfolio management teams may hold different views than the views expressed herein and may make different investment decisions for different clients. Parts of this material may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this material is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any service, security, investment or product outlined in this material may not be suitable for a prospective investor or available in their jurisdiction. Copyright in this material is owned by Barings. Information in this material may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.