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What’s The Buzz: High Yield - High Enough?

What’s The Buzz: High Yield - High Enough?

March 06, 2024

With fixed income yields finally higher (and more rational), many investors have been drawn to the space, attracted by its risk/reward characteristics given the higher yield.  We ourselves have put forward the proposition that fixed income is attractive from both a yield perspective and risk/reward versus other asset class perspective. We have not been alone in this view as funds have continued to flow into both investment grade fixed income and high yield fixed income. This can be demonstrated by exchange traded fund (“ETF”) flows:

A large part of this inflow has been due to the additional yield now available on corporate debt (investment grade and high yield).  The yield, while attractive compared to where it has been during the zero-rate decade, is currently near its 20-year average although it is 90 basis points above the 20-year average excluding the global financial crisis (“GFC” – measured in this research as June 2008 – November 2010). Please note that the data on “the market” comes from the Bloomberg US Corporate High Yield, and as a result exclude non-investment grade loans, privately placed debt, and issues with less than $150 million outstanding (among other inclusion criteria).

Yield, however, does not tell the whole story.  The spread, or “risk premium” you are paid for investing in these markets is a necessary component to the story. The spread to treasuries (the “risk-free rate”) measures how much you are being compensated for the default risk of the securities. As the following charts show, the spread, whether viewed over the last 10 or 20-years including or excluding the GFC and COVID, is below average.

The risk premium has tightened across the rating spectrum, one rating category has not had a disproportionate impact.

Another way to look at this is the risk premium as a percentage of the total yield.  Over the last twenty years, the risk premium has been 65 percent of the total yield-to-worst, it currently stands at 40 percent of the total yield-to-worst.  In other words, the yield increase has been a result of the increase in rates, not an increase in risk premium.

This effectively means you are getting paid less for default risk than you have historically.  This has occurred as the composition of the index (Bloomberg US Corporate High Yield) has slightly shifted to lower quality.

Shown differently, we can better see that “B” rated corporates have taken share from “Ba” rated corporates, increasing the probability of default (as that is all, essentially, ratings measure).

Given this shift, the high yield market has become more “sensitive” to an increase in default rates, and should price appropriately (recall the risk premium is lower than average).

Default risk is, as we have mentioned, the reason high yield is, well, high yield.  Defaults have vacillated between 2-6 percent post GFC, as the Moody’s Investors Service chart below shows. The chart also shows that Moody’s baseline forecast is for the default rate to decrease over the coming year.

A look at spreads and default rate also shows something interesting.  Spreads tend to lead default rates by approximately one year (peak to peak).  Should this relationship hold, it is a positive sign.

Speaking of risk, it is also important to understand the correlation between the high yield market and the equity market.  For this we are using the Russell 3000 as the broad market, Russell 1000 as the large capitalization market, Russell 2000 as the small capitalization market, and Russell Midcap as the “middle” capitalization market.

As the above charts evidence, and as we have written about previously, the correlation between high yield and equities is near its high and well above average.  While this is consistent with the fixed income markets generally (see below), the high yield market has always had a higher correlation with equities and this must be considered when allocating portfolio capital.  Importantly, the correlation is higher (currently and on average) with large-caps and mid-caps which must be recognized given the prominence of large-cap equities in most portfolios.

Finally, a look at OAS “Z-scores”, or standardized measure across both fixed income asset classes and within high yield by rating.

Within fixed income: 

Across fixed income, high yield is currently not attractive when looking at where the OAS of the asset class is relative to its historical norms.

Within high yield: 

Within high yield, the most attractive area, according to the z-score, is the Caa rated bucket, arguably the hardest bucket to invest in given the probability of default (hat tip to the folks who manage in this space).

Conclusion

While we find the yield available in the high yield space to be compelling, we are cautious on the sector due to the low risk premium (spread) currently available.  That said, should the economy avoid a recession (or, importantly, an earnings recession) and the default rate level off or fall, the sector has an attractive yield associated with it.  Barring a dramatic fall in rates, we do not expect significant capital appreciation as spreads have already contracted and the earnings outlook does not paint of picture of robust earnings and, hence, balance sheet strength. We currently have exposure to the asset class for the income and the possibility for some capital appreciation (again, not significant).


Disclosures/Definitions

The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield in the middle rating of Moody's, Fitch and S&P is a Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded. 

The Bloomberg USAgg Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

The Russell 1000 Index measures the performance of the large-cap segment of the US equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 93% of the Russell 3000® Index, as of the most recent reconstitution.

 The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe and is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

 The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.

The Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 25% of the total market capitalization of the Russell 1000 Index.


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