High-yield returns have usually been positive during previous rising interest rate environments because of the correlation between rising rates and economic growth. However, today's high-yield market is clearly more vulnerable to rising interest rates than it has been historically, as overall credit quality has improved and coupons have shrunk.
On a more positive note, credit trends in the U.S. high-yield market remain stable. The quality of high-yield bonds has improved significantly in the past decade. As of December 31, 2022, the ICE BofA U.S. High Yield Index now comprises 50% BBs (on a par value basis), up from 43% at the end of 2011. At the same time, CCCs have declined to 12%, down from 18% since the end of 2011. (BBs' percentage of the market did decline modestly in 2022, from 54% in 2021, due to the significant volume of bonds that were upgraded to investment grade and exited the high-yield market).
Moreover, the U.S. High Yield market leverage is at its lowest level in 10 years, and interest coverage of 3.5x is higher than the 10-year average of just 2.2x (Source: JP Morgan). The largest high-yield issuers today are generally large publicly traded companies; according to JP Morgan, 69% of the U.S. High Yield market has publicly traded equity.
Figure 1: US High Yield Market Spreads
Even if the U.S. economy heads into a recession, we believe it is unlikely that default rates will spike far above historical norms. Valuations are more expensive after the recent rally but far from excessive in our view. The current spread of 449bps is now tighter than the historical average of 469bps and toward the middle of the “non-panic range” of 350-550. We would expect spreads to remain in this range absent any significant change in market risks.
Given these factors, we are positioned relatively defensively from a credit quality perspective, focused on shorter duration, higher quality bonds.
There are many risks in financial markets today; however, stable fundamentals and reasonable valuations suggest that U.S. high yield continues to represent a reasonable, lower duration fixed-income investment option.
Source Information
ICE Data Indices, LLC (“ICE Data”), is used with permission. ICE® is a registered trademark of ICE Data or its affiliates, and BofA® is a registered trademark of Bank of America Corporation licensed by Bank of America Corporation and its affiliates (“BofA”) and may not be used without BofA’s prior written approval. ICE Data, its affiliates and their respective third-party suppliers disclaim any and all warranties and representations, express and/or implied, including any warranties of merchantability or fitness for a particular purpose or use, including the indices, index data and any data included in, related to, or derived therefrom. Neither ice data, its affiliates nor their respective third-party suppliers shall be subject to any damages or liability with respect to the adequacy, accuracy, timeliness or completeness of the indices or the index data or any component thereof, and the indices and index data and all components thereof are provided on an “as is” basis and your use is at your own risk. ICE Data, its affiliates and their respective third-party suppliers do not sponsor, endorse, or recommend MacKay Shields LLC, or any of its products or services.
CREDIT RATING DISCLOSURES (FOR INDEX)
ICE BA Credit Ratings
ICE BA utilizes its own composite scale, similar to those of Moody’s, S&P and Fitch, when publishing a composite rating on an index constituent (eg. BBB3, BBB2, BBB1). Index constituent composite ratings are the simple averages of numerical equivalent values of the ratings from Moody’s, S&P and Fitch. If only two of the designated agencies rate a bond, the composite rating is based on an average of the two. Likewise, if only one of the designated agencies rates a bond, the composite rating is based on that one rating.
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About Risk: High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. These securities can also be subject to greater price volatility.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
The following indices may be referred to in this document:
ICE BofA US High Yield Index
The ICE BofA US High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. The ICE BofA US High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch) and an investment grade rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long term sovereign debt ratings). In addition, qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and U. S. domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index.
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