Seeking High-Yield Alpha at a Market Turning Point

The recent upswing in 10-year Treasury rates has investors wondering what an environment marked by low, but rising, interest rates could mean for their fixed income allocations – and what comes next if inflation accelerates. While the headlines may be unsettling, we believe that high yield bond investors should avoid short-term distractions and focus on the broader trends, which are more positive than many may believe.

What the dominant, negative narrative is missing is that the very factors driving rate increases, including a brightening economic outlook and strong credit fundamentals, stand to benefit leveraged debt markets and improve the risk profiles of underlying companies. Moreover, high yield has been a strong performer during recent episodes of stock market volatility and, notably, in past periods of rising rates.

We will be the first to acknowledge that return expectations across fixed income markets are unlikely to materially exceed long-term averages this year. However, given high yield bonds’ attractive yields versus core bonds, along with their lower duration, diversification benefits, and favorable default forecast for 2021 – all against a supportive, expansionary macro backdrop – we believe investors could benefit from allocations to the segment this year.

Late-cycle valuations meet early-cycle fundamentals

Much of our constructive view on high yield bonds comes down to supportive fundamentals amid a cyclical turning point. Essentially, what we’re witnessing today is an unusual market in which late-cycle valuations are finally being justified by early-cycle fundamentals. Yes, valuations may be elevated from a historical perspective, but we’re also at the beginning of an economic recovery, with massive fiscal stimulus and the broad rollout of Covid-19 vaccines in the US fueling stronger growth and market optimism. The employment picture also is brightening, with the addition of 379,000 US jobs in February and another 916,000 non-farm jobs in March, up significantly from prior months, with particular gains in leisure and hospitality.1 Taken together, these trends are driving consensus estimates for real GDP growth of 5.7% in 2021 and 4.0% in 2022.2

Against this backdrop, while high-yield bond yields and spreads are at historically tight levels on an absolute basis, a look beneath the hood shows that quality is higher as well. As a percentage of the overall US high yield market, the portion of issuers rated BB is near all-time highs, while those rated CCC and below is near all-time lows. This is due to a variety of factors, including very high levels of fallen-angel downgrades from investment grade (IG) in 2020; a relatively elevated level of defaults in 2020, particularly in the energy sector, which cleared out the most distressed issuers; and a multiyear shift in new-issue supply away from CCC rated leveraged buyout (LBO) financings toward BB and B rated issuance by public companies. Overall credit quality is historically high at a time when the macro backdrop is broadly supportive of the issuer base. That said, fundamental volatility and default risk remain facets of the asset class, and current valuations leave less room for error. This means security selection is critical.

BB and B Rated Debt Dominates the High Yield Market

High-yield ratings distribution (left axis) and market size (right axis)

Source: Bloomberg as of 6 April 2021. Data shown for the Bloomberg Barclays US Corporate High Yield Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change.

Defaults are trending down

Given the improvement in credit quality, the default forecast for high yield also looks favorable for 2021. After rising to 7.4%3 in 2020 amid Covid-related disruptions, primarily affecting the energy sector and lower rating tiers (CCC and below), we expect the default rate to drop to 3% or lower this year – a manageable level that is in line with historical averages. It’s also worth mentioning that when investors ask about high yield default risk, what they are really asking about is CCC default risk, because over 80% of HY defaults happen in this rating tier. With many of the lowest-quality high yield credits having fallen out of the market via default in 2020, stronger companies remain, and an influx of fallen angels entering the top high yield rating tiers also lends support. The overall high yield bond market looks much healthier than it did at the end of 2019, auguring well for a significant decline in defaults going forward.

Outlook for 2021: Fewer Defaults, and Most Will Likely Affect the CCC Tier

High yield trailing-12-month default rate by credit rating

Source: Bloomberg as of 31 March 2021. High Yield is the Bloomberg Barclays US Corporate High Yield Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.

High yield has performed well when rates are rising

High yield bonds have been attractive to investors looking beyond core allocations as yield remains elusive. And while concerns about rising rates have dominated recent commentary, it’s important to remember that the factors at work beneath the rise in rates – including a strengthening economy, massive fiscal stimulus, easy monetary policy, and the release of significant pent-up demand – tend to benefit the high yield segment. The bottom line is that improving fundamentals trump rates when it comes to performance in high yield markets.

Lessons from the past bear this out. While we may see a temporary effect on credit spreads while rates move up, fundamentals tend to quickly take over as the primary driver of performance. As the chart below shows, high yield spread tightening has tended to pause when Treasury rates rise, but then improve and return to normal within a few months.

High Yield Has Performed Well in Rising Interest Rate Environments

High yield performance when 5-year US Treasuries rose 70 bps or more in three months

Source: Barclays, PineBridge as of 31 December 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Past performance is not indicative of future results. Any views represent the opinion of the investment manager and are subject to change.

Where we’re seeing opportunity

High yield bonds continue to offer investors the opportunity to diversify their portfolios and pick up yield with less interest-rate and repayment risk, particularly when compared to core fixed income assets. Below-IG corporate spreads, though historically tight, remain more than triple those of IG corporate bonds, whose duration is more than twice as long. 

High Yield Spreads Are More Than Triple Those of IG Bonds, with Less Than Half the Duration Risk

Source: Bloomberg as of 6 April 2021. Data shown for the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays US Corporate High Yield Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager, are valid as of the date indicated, and are subject to change.

We see the most compelling opportunities in the BB and B ratings tiers, where defaults have been minimal historically and where tailwinds should buoy the market this year. We see more limited, tactical opportunities in lower-rated CCC issues, but we think current trading levels do not support being materially overweight the lowest rating tier given its proportionally higher default risk.

Looking at business and industry segments, we expect those that are benefiting from the Covid recovery and some cyclical sectors to be relative outperformers, including the travel, leisure, gaming, and lodging sectors. As we see the individual issuers reopen, we are seeing a pretty material bounce back in their revenue and cash flow profiles relatively quickly. Finally, after five years, energy looks attractive again. We view the sector today as more of an opportunity than a risk. BB rated energy credits were restocked with fallen angels in 2020, and much of the worst of the sector in the B and CCC rating tiers left the market in 2020 via default. The new HY energy sector is much better positioned now than it was as constituted before the pandemic, particularly with respect to resiliency to oil price shifts.

Cyclical and Covid-Affected Sectors Still Offer Issuer-Specific Opportunities

Covid vs. non-Covid sector spreads (bps)

Source: Bloomberg Barclays as of 26 February 2021. High Yield is the Bloomberg Barclays US Corporate High Yield Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.

An alpha-driven high yield market in 2021

That we see so few risks to the near-term economic outlook leaves us looking for sources of volatility contrary to our thesis. The move in US Treasuries to date this year has been jarring, and while we expect rates to stabilize near current levels of 1.7%, volatility is likely to continue until the question of whether inflation exceeds the Fed’s 2% target is settled. Additionally, interest rates are more likely to be higher than lower over the remainder of this economic cycle until the Fed ramps up its purchases. There will be material issuance of Treasuries to fund current and future fiscal deficits.

Expectations for Treasuries, GDP growth, and Fed policy for 2021 will have an impact on the long-term risk premium, laying the foundation for credit spreads to test all-time tights. Looking forward, we believe that the positive economic outlook and improving credit fundamentals will result in resilient high yield bond spreads over the coming year, with potential for tightening in certain industry sectors and rating tiers.

We believe this is likely to result in returns exceeding those for core investment-grade fixed income. Lower absolute spread levels and an established economic recovery suggest that the beta opportunities of 2020 are giving way to a more alpha-driven market in 2021, where security selection will remain critical for high yield investors.