Market Views: Will high-yield bonds shine if interest rates slide?
Global high-yield bonds have delivered strong risk-adjusted returns over many years for patient investors. As US interest rates peak and are poised to decline, issuers should benefit from lower financing costs, improved cash flows, and stronger bond demand.
While the Asian high-yield bond market experienced turbulence due to China's property woes, the situation has stabilised, with Asian high-yield bonds delivering a robust 12% return year-to-date.
Should the Federal Reserve initiate rate cuts this month and the US economy eventually achieve a soft landing, fund managers view high-yield bonds as an attractive investment option, offering relatively lower risk than growth assets and respectable returns. Some even consider them a public alternative to private credit.
However, if the global economy deteriorates more severely than anticipated, along with other uncertainties such as geopolitical developments, the argument for high-yield investments could weaken.
We have collected insights from fund houses on how institutional investors should approach the high-yield bond market as interest rates fluctuate.
The following responses have been edited for brevity and clarity.
Ian Samson, portfolio manager
Fidelity International
The team has a broadly positive view on credit overall from multi-asset perspective. In particular, we prefer quality high yield over investment grade bonds.
High yield fundamentals look stable. Global growth continues to moderate towards trend levels, but we believe the recent fears over an impending recession in the US are overblown.
The earnings of corporate high-yield issuers still look solid, while aggregate default rates and credit stress are well under control. There are some signs of stress in private debt markets, however even these are being well contained by cash rich sponsors.
Notably, the credit market was largely unaffected by the recent market volatility. Credit markets remained priced for a soft landing in US growth, which appears the most likely outcome.
Despite tight spreads, overall all-in-yields still look attractive, especially with policy rates falling and yields once again diversifying against equities and other portfolio risk. As such, with heightened equity market volatility likely to persist in the run up to the US election, quality high yield offers good risk-return.
Within HY, we prefer shorter-dated bonds as uncertainty around interest rates is still high and we believe this area of the market has better risk-adjusted return.
Julio Callegari, CIO for Asia fixed income
JP Morgan Asset Management
The Asia high-yield market continues to offer an attractive source of carry for fixed income investors.
Excluding the relatively idiosyncratic China real estate bonds, the JACI (JP Morgan Asia Credit Index) High Yield index still provides pick-up of nearly 200 basis points in spreads, compared to developed markets’ HY bonds.
While the risk of a US recession is increasing, and high yield bonds typically underperform in a "risk-off" scenario, there is still a strong investment case to include Asia high yield bonds in portfolios.
Firstly, although a US recession is a risk, it is not our baseline scenario. Relatively solid earnings and the Federal Reserve's easing measures should help support a soft landing.
Secondly, we believe that economic growth in Asia will be more resilient than in the US as we approach the end of the year and move into 2025, which should support the outperformance of Asia HY at the macro level.
Additionally, on the technical side, we anticipate limited issuance in the Asia HY USD space, as many corporates can secure funding in local markets at reasonable costs.
Therefore, we remain constructive on the higher quality segment of the Asia HY market (excluding China real estate), particularly in the BB and B rating categories where the risk of default is significantly lower compared to the CCC space. Within this segment, we favour sectors that are less sensitive to the US economy, such as Macao or Indian utilities, and corporates with reasonable cash levels and access to local funding.
Henry Loh, head of Asian credit
abrdn
We remain constructive on Asia high-yield generally, seeing it as a way to enhance portfolio yields through high yield issuers that are in much better shape today.
The asset class has changed notably since five years ago, with much higher average credit quality (as seen through the improvement in average rating to BB-), less exposure to the troubled Chinese real estate sector and evidence of fundamental improvement in many higher beta issuers.
This in part explains the strong rally Asia high yield has staged since the lows of 2022, leaving Asia high yield spreads at levels that reflect much of the positives in the market (barring several corporates and issuers facing distress).
A US rate cut cycle likely bodes well for Asia high yield issuers in the medium term supporting a continued Asia high yield allocation, with lower financing costs and positive support for bond demand.
However, amidst headwinds of a softer US economy, and perhaps more importantly, geopolitical overhangs, we look for high yield bonds that can serve to boost portfolio yield and are better placed to weather the potential turbulence on the horizon.
We see issuers in India being more insulated from global currents given the shape of the economy and its geopolitical positions. Additionally, issuers with more utility-like revenue streams or subordinated bonds of higher quality issuers are likely to demonstrate better stability through this uncertainty.
A particularly positive sign of late has been the resumption of Asian high yield primary issuance – lower overall yields will likely further support this, and continue to reduce refinancing risks in the region.
Rong Ren Goh, portfolio manager, fixed income
Eastspring Investments
High-yield bond performance is likely to be driven by the underlying risk environment rather than the prospect of Fed cuts (and lower rates) per se.
Notably, high-yield bond performance held steady in 2023 even as base yields ground higher. The slow/no-landing macro narrative has been conducive for carry trades, including HY bond investments, to thrive.
Asian HY has had a good run year-to-date amidst low volatility and investor demand for carry in a benign risk environment, returning over 12% year-to-date. Spreads have resultingly compressed, with yields currently about 8%. This compares to around 5.5% on the blended Asian Credit Index. Spreads are trading at three-year tights, suggesting valuations may be expensive, even if absolute yields remain high.
The past two to three years have been more challenging in the Asian HY space, as the segment was beset with defaults amongst Chinese real estate issuers. This has since passed, and we now have an investible universe with a significantly lower risk of default even as we approach the end of the current economic cycle.
That said, we also have to consider the price risk associated with investment into the HY space. There is a tendency for HY spreads to widen out a lot more than investment grade spreads during periods of risk retrenchment.
As we navigate the final legs of 2024, beginning with a seasonally volatile September for markets, accompanied by US elections and increased geopolitical tensions in select regions, we therefore prefer to tread the HY segment more cautiously during this period.
Paul Benson, head of systematic fixed income at insight investment
BNY Investments
High yield can provide attractive equity-like returns, potentially in the region of 7-8%, but with relatively lower risk, which makes it an important asset class for investors as the economy slows under the Fed’s orchestrated moderation regime.
Defaults remain very low, and while they are expected to rise, we expect this to be by less than markets anticipate. Economic moderation is also likely to boost supply of fallen angels, former investment grade companies that have been downgraded to high yield, which creates opportunities for investors able to exploit market structural inefficiencies and relative value mispricing opportunities.
High yield continues to be a compelling public alternative to private credit, where high demand has caused a build-up in dry powder. Estimates suggest half a trillion US dollar is currently sat on the sidelines. Spread compensation for the additional illiquidity, complexity and idiosyncratic risk of private credit is also shrinking rapidly, with high yield, in our opinion, offering better liquidity and potential for diversification.
Systematic strategies are finally hitting the mainstream in fixed income and are well suited to gaining high yield exposure. We see many reasons to be excited about this long-awaited technological revolution in bonds.
Over a decade ago we pioneered a credit portfolio trading protocol which aims to unlock hidden liquidity within the fixed income ETF ecosystem. Instead of trading bonds one at a time, the protocol trades baskets of bonds, potentially 500 or 1,000 at a time.
We believe systematic approaches can complement and diversify traditional strategies, potentially delivering more reliable returns and enhanced liquidity.
Adam Darling, investment manager, fixed income
Jupiter Asset Management
Combining short duration and regular coupon income, high yield has proven to be inherently less volatile than equities but still offers attractive total return. It performs a valuable diversifying function in investor portfolios and should be viewed as a core holding over time.
While all-in yields still remain attractive at over 7%, credit spreads are tight in many areas of the market (particular in the US) and there are some signs of fraying investor discipline. This reflects bullish investor sentiment about an economic soft landing, which has – to some extent – pulled forward the assumed benefits of interest rates cuts.
With mixed economic data, including many indicators of potential recession risk, this is not an environment for complacent investing.
If interest rates fall globally because economic conditions are weakening, this is not necessarily beneficial for all high yield bonds as weaker companies may struggle.
Investors should look to allocate through active high yield strategies which offer a proven track record, a global focus, and a robust credit analysis framework which enables investors to benefit from the best opportunities in the sector while mitigating default risk.