High-Yield Bonds: Yields Are Up, But Risks Remain

Coming into the year, we were cautious on high-yield bonds given the risks of rising rates and tighter financial conditions. Investors generally have shrugged off those risks, pulling high-yield spreads down and prices up.

As we look forward, we maintain our cautious stance, but acknowledge that the rising likelihood of a "soft landing" may keep high-yield bond prices supported. While we don't necessarily expect it to happen, a soft landing—where growth slows enough to cool inflation, but the economy avoids recession—could prevent corporate profits and revenues from falling.

More importantly, the starting level of yields generally makes it harder for high-yield bonds to post a loss for a full year even if prices rise. High-yield bonds tend to offer high income payments, which can help offset potential price declines. The Bloomberg US Corporate High-Yield Bond Index offers an average yield of roughly 8.5% which appears relatively attractive if investors plan to hold for a while and can ride out the ups and downs. Since 1990, there have been a total of 96 months during which the average yield of the index ended the month between 8% and 10%, and only 13 times has the index posted a negative return over the subsequent 12 months. A majority of those 12-month losses occurred during the 2008-2009 financial crisis, and all but four of the 13 negative returns were losses of 2.3% or less.

But we prefer investment-grade corporate bonds that have generally have A and BBB credit ratings¹ and offer average yields that are close to 6% with much less credit risk than high-yield bonds.

The risks we have been highlighting are still present, and prices could fall in the next six to 12 months. While we still think there may be better entry points down the road, the yields currently offered have rarely been higher over the last 10 years. For those who are considering high-yield bonds today, we prefer those rated in the BB range as their prices would likely fall less than those rated B and CCC should the economy slow.

High-yield bonds are issued by corporations that are generally deemed less creditworthy than those with investment-grade credit ratings. They might have too much debt relative to their earnings, or a very cyclical business model that results in volatile cash flows. With that sort of profile, there's a greater risk that the issuer won't be able to make timely interest or principal payments and ultimately may default on its debt obligations. That's a key reason why lower-rated issuers offer such high yields—they need to compensate investors for the risk that they might not get their money back as expected.

Another risk is that the compensation earned by investing in high-yield bonds is relatively low today. The extra yield that corporate bonds offer over comparable Treasuries is called a "spread" and it's currently well below its long-term average. The 10-year and 20-year average spreads of the Bloomberg US Corporate High-Yield Bond Index are 4.3% and 5.0%, respectively, and the current spread is just 3.8%.

While the 20-year average includes the 2008-2009 financial crisis, which pulls up the average over that time frame, we can see in this chart below that spreads are volatile and can rise well above the current levels during periods of market stress or economic slowdowns.

Over time, high-yield spreads generally have risen when bank lending standards have tightened, but that hasn't necessarily been the case during this cycle.

This ties into the rise in private credit, which is one of those areas where high-yield bond companies may turn to for financing rather than issue in the public high-yield markets.

Finally, the types of default have shifted over the years. Distressed exchanges now make up a large share of corporate defaults these days. A distressed exchange is when an issuer preemptively negotiates with lenders to work out a deal in advance rather than filing for bankruptcy and working it out in the courts. Note that the negotiations are usually with large institutional investors, not with individual investors. These are still considered defaults because the lenders usually receive a "haircut" on their debt—meaning an amount less than the stated principal value—along with an extended maturity. But the outcomes may be better than leaving it to the courts while trying to figure out what the potential recovery value of the defaulted bond is. Unfortunately, according to Standard & Poor's, for companies that default through a "selective default," which includes a distressed exchange, there is a 35% likelihood that the issuer could default again in the next four years. In other words, a selective default doesn't necessarily solve the problems that the issuer may have.²

Corporate bonds rated B and CCC tend to have the highest default rates, so we prefer high-yield bonds rated BB today. While we prefer a defensive approach to high-yield bonds for now, over time BB rated bonds tend to outperform B and CCC rated bonds, and with less volatility. Defaults have already begun to pick up lately. According to S&P, the trailing 12-month speculative grade default rate was 3.5% through the end of July, up from just 1.3% in July 2022, and it's expected to rise to 4.5% by June 2024.³

And like most bond yields lately, the average yields of BB rated bonds are up sharply and are currently at levels rarely seen over the last 12 years. But keep in mind that much of the recent rise in yields is due to the increase in Treasury yields rather than a rise in spreads. While BB rated bonds might not default frequently, their spreads would still likely rise over the short run should the economic growth outlook deteriorate.

We still believe high-yield bonds should underperform Treasuries and investment-grade corporates over the next 12 months. But from a long-term strategic standpoint, the 8.5% average yield that high-yield bonds currently offer represents a high starting point for investors who plan to hold for the long run and can ride out the ups and downs. For those willing to ride out those fluctuations, we favor high-yield bonds with BB ratings to help limit the downside.