9 September 2021
Highlighting high yield
High yield has already meaningfully outperformed other fixed income sectors this year and global economic growth is starting to slow, but we believe there is still a case for holding high yield bonds.
High yield has benefited from an improving macro backdrop but leading economic indicators, such as purchasing managers’ indices (PMIs) across the globe, have started to lose momentum, which has led to downgrades in growth expectations. We remain comfortable that the backdrop will be supportive going forward as the slowdown reflects temporary supply shortages rather than inadequate demand. There is currently an unprecedented gap between inventory growth, which has been weak, and sales growth, which has been strong, but we expect the supply issues to be alleviated in the coming quarters. Employment data this month was mixed. Non-farm payrolls disappointed in the US, printing at 235,000 versus an expected 733,000, indicating employment growth likely slowed in August due to the spread of the Covid Delta variant. However, other employment indicators, such as the unemployment rate and wage growth, continued to improve. A September taper announcement by the Federal Reserve is now very unlikely, but 2021 is still the base case. While the monetary policy punchbowl isn’t being pulled away yet, corporates continue to post solid earnings results and default rates have fallen significantly to 1.1% in the US and 2.1% in Europe at the end of August; we expect them to continue to fall, ending the year below 1%. Rating trends also continue to be positive with 2.4x more upgrades than downgrades in the US and 1.6x in Europe.
High yield’s returns so far this year have been impressive, especially considering that underlying government rates have detracted from returns. Consequently, US and European high yield spreads stand at 316 basis points (bps) and 294 bps, respectively, having already tightened 70 bps and 65 bps this year. Therefore, there is not much room for error. While spreads could still compress versus their all-time tights, we think that they will remain range bound for the remainder of this year. This should not scare off investors though, as we believe the carry on offer for high yield (a yield-to-worst of 3.93% in the US and 2.39% in Europe) still looks appealing versus competing fixed income sectors whose carry could be wiped out with barely any move in underlying rates at all. (Data as of 7 September 2021).
High yield has outperformed other fixed income sectors this year
Easy access to funding may have led to benign default rates but it has also meant that high yield investors have had to cope with an elevated supply of bonds. High yield corporates have been active in capital markets, issuing USD 362 billion of debt in the US and EUR 105 billion in Europe, 21% and 83% above last year’s respective levels. Thankfully, a record year of gross supply has been mitigated by refinancing activity, which remains the primary use of proceeds, and rising stars, which have reached USD 22 billion in the US and EUR 20 billion in Europe so far this year, thereby shrinking net supply levels. Retail fund outflows do not paint a positive picture for the demand of the asset class, with US and European high yield fund outflows of USD 18.2 billion and EUR 682 million, respectively, this year, equivalent to 4% and 1% of assets under management (AUM) – but don’t let that fool you. Mandates outside of traditional retail high yield funds have picked up the slack, evidenced by high yield’s returns. Furthermore, US loan fund inflows of nearly USD 40 billion this year, equivalent to 30% of AUM, suggest that while there may be an aversion to duration, there is still ample demand for leveraged credit. With the percentage of negative-yielding debt in the Bloomberg Barclays Global Aggregate index reaching 23% at the end of August, we think that the demand for high yield should persist. (Data as of 31 August).
What does this mean for fixed income investors?
Following a streak of strong returns, high yield valuations have come a long way, leaving some investors asking whether it is worth taking profits here; without a positive catalyst there is not much room left for spreads to tighten. We think that from a valuation perspective, investors will still be rewarded for owning high yield as they will benefit from higher levels of carry. Faced with such a low-yielding environment, we believe the demand for high yield bonds will remain solid, especially when also considering the lower-duration profile of the high yield market, which benefits from relatively higher breakeven yields. All told, we think that robust corporate health, a supportive macro backdrop, the ongoing search for yield and technical tailwinds should outweigh challenging valuations.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum