Preview:
Key takeaways:
- US high-yield (HY) bond issuers today are generally in much better financial shape than they were in the past.
- As a result of the pandemic-led wave of fallen angels and defaults, the average quality of US HY constituents today is higher, contrary to the junk bond perceptions of the past.
- The higher-for-longer interest-rate environment has resulted in historically high yield levels.
- We think income-seeking investors should embrace the US HY sector, rather than avoid it.
HY fundamentals have remained generally healthy
The US HY market has remained resilient in the face of decades-high inflation and steep US Federal Reserve (Fed) rate hikes, due to a combination of fundamentals and technical conditions. In terms of the former, HY credit metrics exited the pandemic in strong shape, with interest coverage at historic highs. This was a result of Fed actions during the initial stages of the pandemic, when it drove US Treasury yields to ultra-low levels and stepped in to support portions of the US HY market, which ushered in an extended period of wide-open capital markets that allowed issuers up and down the ratings spectrum to refinance maturities at historically low rates and build out liquidity runways. While interest coverage ratios have started to decline from their historic highs as maturities are refinanced at prevailing higher rates, we expect the descent to be gradual given the profile of the maturity wall.
In this paper, we try to better understand how high yield bonds have become increasingly higher quality in nature. We consider the following:
- The higher-quality nature of US HY constituents
- Attractive yield levels
- Embrace US HY
- Additional factors:
- The ratings quality of the market is much better than in the past.
- Senior secured bonds represent a significantly higher percentage of the overall market.
- The large energy sector is likely to experience a much milder default cycle than over the past decade.
- The average bond is trading at a significant discount to par that, combined with a relatively short average maturity, implies a strong pull to par.
- We believe current yields should more than compensate for expected default losses.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.