High yield has more to give
Ratings upgrades and rebounding economy create favorable backdrop.
The high-yield market ended 2021 on a high note, with a very strong December lifting the benchmark1 return for the year to 5.26%. This came in a year when the yield on a 5-year U.S. Treasury went from 0.36% to 1.26%, once again proving the resiliency of high yield in a rising-rate environment.
So, what about this year? Obviously, it’s been a bit of a rough start from a total return standpoint. Equity and government bond prices have fallen, dragging high yield along with them. For the year, however, we believe 2022 will resemble 2021 with modest absolute returns and good excess returns versus other fixed-income assets. Treasury rates should go up and we believe spreads—the yield differential relative to comparable maturity Treasuries—still have room to marginally tighten. We expect extremely strong corporate credit conditions, with a big assist from a strong economic environment, to drive performance and for upgrades to again outpace downgrades.
For the high-yield market, most of the action in 2021 revolved around very strong corporate credit conditions. Credit rating agencies upgraded far more debt than they downgraded. However, in 2021, most of these upgrades were within the high-yield market. While this will continue in 2022, it may be overwhelmed by upgrades from high yield to investment grade—estimates suggest 10% to 15% of the high-yield market could move to investment grade. The real impact may be technical as high-yield holders will need to recycle that money back into high-yield bonds, providing a strong bid to the market.
I would note that this mixed dynamic within high yield (that is, low-spread bonds exiting the benchmark) may make it look as if spreads are widening and that we are playing loose with the numbers when we talk spreads moving tighter this year. That’s because the loss of the highest-quality, tightest-spread high-yield credits to investment grade could make it appear that spreads are widening in the remaining high-yield universe, but this may just be an issue of mix within the high-yield market. In any case, this doesn’t change the constructive macro backdrop we expect for this year. Default rates, which ended 2021 below 0.5%, should be very low again in 2022. Estimates range from 0.75% to 2.0% versus long-term averages of 3.56%. I would put my money on the low end.
1 Bloomberg US Corporate High Yield 2% Issuer Capped Index