- Investment Director
Asia ex-Japan, Institutional
Change
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Key points:
- High-yield bonds may offer an opportunity to tap into growth, historically able to provide equity-like returns with lower volatility.
- All-in yields for global high-yield markets are currently attractive — and can also provide a cushion against rising interest rates and widening credit spreads.
- However, spreads are below historical medians, meaning investors may wish to gradually increase exposure over time, capturing attractive yields available currently while holding out for valuation opportunities.
In a higher-yielding but more uncertain world, where should investors look for growth now?
The new macroeconomic era will spell more volatility and cyclicality for investors, but it is also likely to generate higher nominal growth. While equities and alternatives are typically considered the most obvious route to capture this potential, higher yields are making fixed income more attractive than it has been in the past — not only for investors seeking income but also for those looking to grow wealth over the long term.
When thinking about growth through the lens of fixed income, the two most obvious contenders are emerging market debt and high-yield bonds — the fixed income asset classes that have the potential to provide the highest returns for investors.
Emerging market debt — government or corporate debt from emerging market countries — can be a volatile and complex market but may offer the potential for higher levels of income and capital appreciation than developed market debt. However, there is significant dispersion and idiosyncratic risk. For both local and hard currency emerging market debt, we would suggest that exposures should be built up cautiously over the long term, in line with the specific risk appetite and investment horizon of investors.
High-yield bonds may offer another opportunity to tap into growth. Typically issued by corporates of lower quality, high-yield bonds tend to pay higher interest rates than investment-grade bonds and a well-managed active allocation can play an important role in portfolios.
Historically able to provide equity-like returns with lower volatility,1 due to the potential for high and regular coupon payments, high-yield bonds may be a particularly compelling option for investors who are not yet comfortable leaning into equities for growth or who wish to derisk from equities.
The why — high all-in yields and better credit quality may make high yield a compelling option
All-in yields for global high-yield markets are currently attractive — among the highest we have seen since the global financial crisis. Higher yields not only imply higher forward-looking returns, but they can also provide a cushion against rising interest rates and widening credit spreads. Figure 1 plots the historic three-year forward returns achieved between January 1998 and December 2023 and the yield to worst (starting yield assuming no default or early potential issuer redemptions). The figure illustrates that there was a positive historical relationship between starting yields and three-year forward returns over the period and that when yields were at 7.7% or higher, they have tended to translate into positive three-year forward total returns. In fact, when yields were 7.7% or higher, the market had a positive three-year forward annualized total return 85% of the time and the average three-year forward annualized total return was +8.0%. While this historical pattern may not persist, we believe these data points suggest that today’s relatively high yield levels could provide a potentially meaningful buffer to investors.
Figure 1
Another way in which the high-yield market has changed, other than the attractive all-in yields now on offer, is its composition. The high-yield market is larger, more globally diversified and higher quality today.
One reason for this is that an increasingly substantial part of the index is composed of fallen angels — investment-grade bonds that have been downgraded to high-yield bonds in the wake of tougher market environments, particularly in 2009 and 2020. As recent arrivals to the high-yield space, this section of the universe tends to be higher quality relative to the rest of the category and can provide fertile hunting ground for active managers. Another reason for this higher quality is that generally, new issuance has been higher quality, and the high-yield market has been more disciplined — many deals that have come to market haven’t been funded in the high-yield market but have instead gone to other markets, such as private credit.2
Given that high-yield bonds are of lower credit quality than investment-grade bonds, investors are often concerned about the potential for defaults, especially as financial conditions tighten. While we think that defaults will move higher in the coming year, we believe they will remain well below that experienced in prior late-cycle periods, and a higher-quality index should translate to fewer defaults overall. It also helps that corporate fundamentals in the high-yield space are generally solid, without any obvious buildup of leverage in particular sectors or excessive growth in credit across the market from broadly weaker underwriting standards.
The when — patience may pay off but be prepared
Finding the most advantageous entry point may be less of an issue for investors looking to build a strategic allocation, but we would still advocate a gradual approach. Spreads are below their historical medians, meaning that investors may wish to hold out for opportunities to tactically add exposure at more attractive valuations.
For this reason, it may make sense to gradually increase exposure and build up a strategic allocation to high yield over time. This may enable investors to capture the attractive yields on offer today while being open to opportunities in the future. That said, it’s also worth remembering that higher all-in yields can provide important protection from potential spread widening.
The how — the benefits of an active approach
We expect to see continued dispersion between regions this year, and active global high-yield strategies may be able to benefit from opportunities in different economies. Spreads in Europe are currently wider than in the US market, potentially offering investors attractive opportunities to find value — provided the companies issuing them are well positioned to successfully navigate what may be a weaker macroeconomic backdrop.
If investors choose to allocate to high-yield bonds, we think active management is crucial in the current environment. While the high-yield universe is generally higher quality than it was in the past, broadly speaking, company fundamentals are starting to weaken, and defaults are ticking higher. In our view, deep, fundamental credit research coupled with deep sector and ESG expertise provides the most effective way to identify high-yielding companies that are best positioned to outperform over the long term — and avoid companies most at risk of default.
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1Source: MSCI, Bloomberg, December 2023. | 2Source: JP Morgan, September 2022.
