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When coupons are king: the case for global high-yield credit

High-yield bonds were particularly affected during the March sell-off, and the asset class is still trading at attractive valuations. At a time when listed companies are cutting dividends, we believe that high yield’s income-generating qualities means that it has the potential to deliver superior risk-adjusted returns earlier on in the market’s recovery. 

High yield: in the eye of the storm

The dual shock of the coronavirus pandemic and oil-price price war meant that global high-yield credit – which is particularly vulnerable to stressed market conditions – sold off at a rapid pace in March. While companies are doing what they can – cutting dividends, buybacks and capital expenditure, and finding ways to optimise their cost structures – it seems likely that defaults will rise over the next year. 

Ratings agencies have also been quick to respond, and the pace of downgrades has risen substantially. This means that the number of fallen angels – or issuers downgraded to high-yield status – has soared in recent months. 

The silver lining is that credit quality within the global high-yield market is currently much higher than during previous drawdowns. The number of fallen angels, coupled with the fact that more leveraged financing has taken place in the loans market, means that the average credit rating of the high-yield market has improved and now stands at BB-. 

Seeking income: high yield or equities? 

Unprecedented levels of central-bank stimulus have helped to ease volatility since the March sell-off. However, the asset class is still trading at attractive valuations: convexity are concerns all but banished and yields and spreads also offer the chance to gain attractive levels of income.

Amid this surge of central-bank support, investors have started to think about how to take advantage of attractive valuations as they continue to manage the effects of the crisis. With investors hungry for income, equities and high-yield bonds are natural considerations. 

Not only has global high-yield credit delivered better risk-adjusted returns than equities over the past 15 years, it has also recorded lower drawdowns. This is in part because high-yield credit sits above equities within the capital structures of companies, and so takes priority during bankruptcies (and therefore provides a greater degree of protection). But high yield also offers the opportunity to capture the upside. Over the past 15 years, it has delivered almost 60% of the upside of equities with only 40% of the downside.

The income-generating qualities of high yield – or the fact it pays investors coupons – helps explain why it has been able to generate relatively attractive risk-adjusted returns. Figure 1 shows how high yield has regained lost ground more quickly than equities after both the 2001-2 and 2008 market crashes. 

Source: ICE Bond Indices, as at March 2020. The US high-yield market currently accounts for more than half of the global market, so is seen as a good proxy measure. 

This resilience is partly due to the fact that the coupons of high-yield bonds tend to deliver income much sooner in the cycle than equities do. Companies that issue bonds are legally obliged to pay out coupons in all market conditions, while dividends are dependent on performance and are delivered after all interest has been paid.