Jack Holmes is co-manager of Artemis Funds (Lux) – Global High Yield Bond
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The high-yield market could do with a good PR agency. Barely a day goes by that we don’t have someone decrying the irrational behaviour of investors within the asset class. When yields are particularly high, commentators opine that investors are allocating money to companies on immediate verge of bankruptcy; when yields are low, the view is that investors are falling over themselves to give money to barely credible business models. As someone involved in the market, I could be forgiven for wondering if I had made a career mistake.
But once the immediate despair has passed and rational thought takes over, the arguments made by the critics do not stand up. The first point – and one that has been oft repeated over the last six months or so – is that the high-yield market will crash as interest rates rise. According to the narrative, the low interest rates since the global financial crisis have driven investors to lend money at barely positive interest rates to 'zombie' companies that will fail and leave investors nursing heavy losses.
But there are a lot of holes in this argument. First, are interest rates really so low? While high-yield credit spreads are far from the widest seen at times of stress, they are more or less at the median level observed over the almost quarter of a century for which we have data. If we exclude periods of extreme market stress (the financial crisis, the energy bust, and the Covid-19 lockdowns) then current spread levels are above the median levels seen in the past.
In terms of absolute yields, US-dollar-denominated BBs and Bs (which together make up 65% of the developed global high-yield market) trade at 5.49% and 6.81% respectively. The median level of fundamental credit losses for these ratings categories going back to 1983 has been 0.3% and 2.0% respectively. This implies a very healthy buffer over likely credit losses of almost 5% for both of these core parts of the market. While there are undoubtedly areas of concern – emerging-market high-yield and CCC-rated securities being the most obvious – the core of the high-yield market is offering attractive yields relative to the fundamental credit risks being taken.
Duration risk or credit risk?
But, the argument continues, rising interest rates will cause high yield – as the riskiest part of the fixed-income market – to underperform. Well, the simple fact is that ‘risk’ is not a linear concept within fixed income. Crudely, there are actually two opposing forms of risk – duration (exposure to interest rates and yield changes) and credit (risk of the entity you’re lending to going bankrupt) risk.
High yield has a lot of credit risk – hence the higher yields to compensate – but actually very little duration risk. And yet duration is the part of fixed income that tends to get hurt in central bank hiking cycles. So while government and investment-grade bonds (which tend to have a lot of duration risk, and not so much credit risk) suffer in hiking cycles as yields rise, high yield actually tends to perform well. Indeed, over the last two Fed hiking cycles high yield has significantly outperformed wider fixed income and delivered high-single-digit percentage annualised returns (see Chart 1).