High-yield fundamentals remain solid High-yield fundamentals remain solid http://www.federatedinvestors.com/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\article\hiker-near-mountain-small.jpg June 4 2021 May 18 2021

High-yield fundamentals remain solid

Asset class continues to offer investors favorable relative returns.

Published May 18 2021
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The high-yield market had a solid April with benchmark returns up 108 basis points benefitting from good economic growth, strong earnings, higher equity prices and an actual move lower in rates. The market has since taken back some of those gains on inflation jitters. Good credit fundamentals, but rate pressures that keep absolute returns modest may be 2021’s continuing saga. We started the year anticipating low‐to mid‐single-digit returns for high yield, and that’s looking about right.

We disagree with market pundits suggesting a retreat from high yield. From our perspective, rate pressures will keep absolute total returns modest, but relative returns should remain attractive. It’s true that volatility will likely be high as various factors such as inflation fears, rising rates and equity market volatility make the ride a little bumpy. At year end, however, we believe high yield is likely to outperform most other fixed assets. Current valuations are a little thin with spreads—the yield differential relative to comparable maturity Treasuries— modestly inside 400 basis points versus historical medians of a little more than 500 basis points. But we think they are going to tighten. Here’s why:

  • The economy is set to boom Driven by reopening, fiscal stimulus and monetary stimulus, 2021 gross domestic product growth will likely be the best in several decades. In March of 2020, most economists were talking about GDP not surpassing the December 2019 level until late 2022 or 2023. It is now expected to occur in the second quarter of 2021. This is a positive for credit sectors.
  • Corporate earnings should be strong, driven by GDP growth Also, companies have done considerable cost cutting during Covid-19. Some, but not all of these costs will return, which should enhance margins. Our analysts’ daily earnings reports all start with numbers that are either above expectation, very strong or a blowout.
  • Default rates are likely to plunge At the beginning of the year, strategists were calling for default rates of 3% to 6%. More recent estimates are in the 2% to 3% range, which we believe is still too high.
  • Risk is relatively tame In late 2019, spreads weren’t far from where they are today, and we moved to underweight high yield in our multi-sector portfolios. At that time, we talked a lot about the fat tail holding spreads artificially high. In 2019, the fat tail was the 8% to 10% of the market that was probably going to default and that was trading at unrealistically high spreads. Today the fat tail is miniscule, and the stated spread level can be achieved without taking too much risk.
  • Mergers and acquisitions are on the increase This is typically a positive for high yield as these deals commonly underscore a desire for management teams to strengthen balance sheets and reduce cost of debt capital.

One more consideration. Historical spreads are a useful guidepost, but circumstances change from cycle to cycle. For example, in mid‐2007, BB-quality bonds made up just 37% of the high-yield market. Today they make up 53%. The lowest-rated CCC bonds have shrunk from 19% to 13%. That alone counts for 20 basis points in overall market spreads.

When spreads are at these levels, there isn’t much room to absorb unforeseen events, so week-to-week volatility may be higher than during past periods of strong excess returns. Our view is that any material sell-off driven by rates, inflation and other such factors will present a buying opportunity.

Tags Fixed Income . Markets/Economy . Interest Rates .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings BB and below are lower-rated securities ("junk bonds"); and credit ratings of CCC or below have high default risk.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

High-yield, lower-rated securities generally entail greater market, credit, and liquidity risk than investment-grade securities and may include higher volatility and higher risk of default.

Federated Investment Management Company