Public Fixed Income

Is High Yield in a Sweet Spot?

April 2021 – 7 min read
High yield continues to benefit from supportive tailwinds—from an improving default picture to lower sensitivity to rising rates—and may be poised for strong performance as the recovery takes hold.

The post-pandemic high yield market is coming into focus. While it will take time for economic activity to return to normal, particularly given rising COVID cases in some parts of the world, expectations remain for a strong recovery in the months and year ahead.

Rising rates continue to dominate headlines, and it is perhaps no surprise that loans have outperformed bonds to start the year, returning roughly 2% in both the U.S. and Europe.1 However, while there are certainly benefits to floating rate assets like loans in a reflationary environment, high yield bonds also look relatively well-positioned, particularly in Europe, where returns reached 1.6% for the quarter given the market’s insulation from U.S. Treasury yield volatility. U.S. high yield bonds, despite lagging the broader high yield market, have shown resilience relative to some other fixed income asset classes, returning 0.95%.2 This is due in part to the asset class’ shorter duration profile—whereas investment grade corporates, for instance, have an average duration of slightly more than seven years, high yield bonds have a duration of roughly four.3

Early Signs of Recovery

From a fundamental standpoint, default expectations continue to improve. Given that distressed ratios are at multi-year lows and both the bond and loan markets are awash with liquidity, we believe defaults this year could fall in line with historical averages of between 2–3%. For comparison, high yield bond and loan defaults ranged from 3–5% last year—much lower than the double digits some initial forecasts were calling for, thanks in large part to the massive global stimulus measures.4 At the same time, earnings, revenues and cash flows are expected to surge higher this year and into 2022 as consumer demand returns.

Given the positive performance of the asset class and improving default expectations, spreads have tightened significantly in recent months, leading to questions around valuations. While bond and loan spreads do appear tight relative to historical averages, the question of valuations is more nuanced—for a few reasons. For one, while spreads have tightened recently, they remain favorable relative to higher-rated corporates, some of which are trading at or near record tights. High yield bonds continue to trade wider than 2017/2018 market cycle lows, for instance, while loans continue to trade wider than both pre and post-GFC tights.

1. Source: Credit Suisse. As of March 31, 2021. 
2. Source: Bank of America Merrill Lynch. As of March 31, 2021. 
3. Source: Bank of America Merrill Lynch. 
4. Source: S&P; Credit Suisse. As of December 31, 2020.

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Martin Horne

Global Head of Public Assets

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