Is there still room to run from here?
Looking at previous cycles, the high yield market tends to bounce back strongly after a sell-off. This is because as bond prices recover and coupons reset at higher levels, the level of income that bondholders receive increases. This is reflected in the all-in yield, which in the US high yield market moved from around 4% in 2021 to 9% at the start of 2023 and is now around 8%.
This most recent sell-off, however was unusual compared to previous ones. 2022’s sell-off and rise in yields was driven mainly by interest rate increases, not by credit spreads widening. This means that bond prices today remain discounted as the outlook for interest rates has been uncertain. That could now be all about to change as we expect the Fed to start moderately easing policy in the second half of 2024.
This means that there is still significant upside potential for the high yield market through a combination of higher income and continued bond price recovery. It is worth bearing in mind that rallies in high yield can happen very quickly: in the fourth quarter of 2023, the US high yield market delivered a 7% total return as the market priced in rate cuts, with the average high yield market dollar price increasing from $88 in September to $93 by year-end, where it currently remains.
Timing such market moves can be challenging so, we believe, being invested is important to ensure participation in rallies, whilst also benefitting from the higher carry now on offer.
We expect high yield spreads to continue to be supported by broadly healthy corporate fundamentals. We also expect any potential spread widening to be met with buyers, providing further technical support.
That said, dispersion is increasing as high yield companies adjust to a higher rate environment. This is reflected in how little of the US High Yield index is trading at its average YTW level. As of 12th June 2024, ~70% of the index had a YTW between 0 and 7.5% and ~20% had a YTW greater than 8.5%, leaving just ~10% of the overall market with a YTW between 7.5% and 8.5% – the index’s average YTW range for the past year or so.
We believe that active management and prudent fundamental analysis are critical to identify companies that are well positioned to pay coupons on a timely basis and pay back, or refinance, principal.
Over the long term, the high yield asset class has proven its ability to outperform other parts of the fixed income market. This is principally due to the attractive carry component that compounds through time.