High yield bonds have been fairly well behaved compared to the equity markets. But have they been too well behaved?

Much of the selloff in high yield over the past year has been due to rising Treasury rates, not rising spreads between 10-year Treasuries and high yield corporate securities. Spreads peaked in July 2022 at 583 basis points, perhaps beginning to price in recession fears. Since then, they’ve moved lower, approaching 400 basis points today. That’s modestly below median by historical standards, and they now look less attractive relative to investment grade corporates and bank loans.

Recession Signal?
A few months ago we discussed spreads as a recession signal and noted that the four most recent recessions include two milder recessions (Jul 1990 – Mar 1991 and Mar 2001 – Nov 2001), one major recession (Dec 2007 – Jun 2009), and one major but short-lived recession (Feb 2020 – Apr 2020). Using historical spread data we can establish a non-recessionary zone, a recessionary zone, and an ambiguous zone where we’ve seen both recessionary and non-recessionary data points. We focused on investment grade corporate spreads originally. Figure 1 puts current high yield corporate spreads into similar context.

With the exception of the very early days of the Covid recession, before the magnitude of the macroeconomic stress was well understood, spreads of 536 basis points and under have always occurred in non-recessionary periods, while spreads haven’t guaranteed a recession until 963 basis points. At spread levels just over 400 basis points, one could argue the high yield market is no longer pricing in even a mild recession.

Figure 1 – High Yield Corporate Spreads and Recession Zones (1/1/90–1/25/23)
Figure 1 – High Yield Corporate Spreads and Recession Zones (1/1/90–1/25/23)
Source: Bloomberg

Meanwhile bank loans are now out-yielding high yield corporate bonds by almost 1%, while sitting higher in the capital structure. For the return-seeking portion of your portfolio, loans increasingly look to provide better bang for your buck than high yield corporates. For a more defensive posture, we continue to like investment grade corporates as a way to go up in quality, when funded from high yield. Investment grade (IG) corporate spreads are still above long-term median, and a 5% yield is very attractive vs. history.

The chart below puts the relative attractiveness of each asset class in historical context. Since June 30, 2022, IG corporates have gotten more attractive, and bank loans have gotten much more attractive – while high yield (HY) has barely budged.

Figure 2 – Yield profile of IG, HY and bank loans (1/31/97–1/25/23)
Figure 2 – Yield profile of IG, HY and bank loans (1/31/97–1/25/23)
Source: Bloomberg

What About the Fundamentals?
Fundamentals for high yield aren’t terrible. The current supply of BB-rated bonds is a higher proportion of the universe than average, with a maturity wall that doesn’t meaningfully pick up until 2025. This profile perhaps offers a rationale for spreads to have fallen as much as they have compared to history. But some of the upside is now capped.

For an asset class where flows are more susceptible to sentiment, declining corporate profitability could see spreads bump up higher. We might see a better entry point later in the year. In the meantime, investors with outsized allocations to high yield may want to consider loans or IG corporates for better risk-adjusted returns.
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