In brief

• The U.S. high yield corporate bond credit spread is consistent with a  benign growth outlook, not a recession
• Maturity profile, default risk expectations and corporate fundamentals are constructive factors for the long term
• Investors sensitive to near-term bond price volatility should focus more on high grade corporate bonds. High yield bonds would be suitable for those with long-term investment horizon, those who need income and have less aversion towards short-term price movements

Credit spreads are not reflecting a high chance of recession

Investors are divided on the outlook of the U.S. high yield (HY) corporate bond market. The structural fundamentals for high yield bonds are encouraging, but some argue that the current valuation of the high yield benchmark is consistent with a benign economic environment, and potentially at risk of spread widening if the U.S. economy deteriorates.

The U.S. HY corporate bond spread is currently at 545 basis points (bps), only slightly above the 10-year average of 505bps. This level of credit spread is consistent with an economy exhibiting a moderating growth outlook. If the U.S. economy falls into a recession, or at least if investors anticipate the risk of economic contraction, then credit spreads could widen much further. As Exhibit 1 shows, HY spreads widened to at least 900-1000bps in the last four recessions since the early 1990s. During the global financial crisis, the liquidity squeeze pushed spreads even higher. However, the yield to maturity of 8% is attractive to global investors and income seekers.

Exhibit 1: High yield spread and default rate*

Source: J.P. Morgan Economics Research, J.P. Morgan Asset Management. 
*Default rate is defined as the percentage of the total market trading at or below 50% of par value and includes any Chapter 11 filing, pre-packaged filing or missed interest payments. Spreads indicated are benchmark yield-to-worst less comparable maturity Treasury yields.
Data reflect most recently available as of 05/09/22.

Given the Federal Reserve’s determination to control inflation, even at the expense of weaker growth, investors may need to be ready for some widening of spreads in the near term, or downward pressure in bond prices. Even if this weak growth or recession scenario results in declining Treasury yields, benefitting fixed income assets, the high yield market could still experience a greater negative net impact on prices. The wider credit spreads would more than offset the positive impact from lower government bond yields. 

Structural factors favor long-term investors

Although the current valuation of HY bonds may be vulnerable to further growth deceleration, there are several positives that could benefit long-term investors. First, the maturity profile of U.S. HY bond over coming 2 years is not particularly demanding (Exhibit 2). It is estimated that around USD 170billion worth of HY bonds would mature over 2022-2024, less than the USD 190billion for 2025. 

Exhibit 2: Quantity of high yield bonds maturing
Par amount (USD billions)

Source: J.P. Morgan Economics Research, J.P. Morgan Asset Management. 
Data reflect most recently available as of 05/09/22.

Second, the economic recovery in the past 18-24 months has allowed HY bond issuers to enjoy significant rating upgrades. As of August 2022, the upgrade-downgrade ratio stood at 2.08x. While this has come off the peak seen earlier in the year, it is still significantly above previous recoveries, which typically see the ratio peak at around 1.4x-1.6x. The increase in quality of the HY index may be the result of smaller issuers migrating to direct lenders, leaving the HY market with larger companies with stronger corporate fundamentals. We have seen a similar constructive trend in the high rising star to fallen angel ratio.

Third, the share of HY debt trading at distressed level is still very low at 1.6%. This has been a reliable forward-looking indicator for defaults taking place in the following 6-12 months. Elevated energy prices and more prudent management are helpful to support the energy sector, which has one of the largest weights in the HY index.

Such optimism is built on steady improvement in fundamentals. Companies issuing HY debt have collectively seen leverage (long-term debt over earnings) decline since the pandemic. Net leverage is currently at 3.94x, versus 5.22x in 1Q 2021. Interest coverage (earnings over interest expense) went up during the same period from the low of 3.6x in 4Q 2020 to 5.28x in 1Q 2022.

Investment implications

The decision of whether to invest, or stay invested, in U.S. high yield bonds depends on two things. First, is the investors’ view on U.S. economic outlook. We would argue that current valuation has not fully reflected economic challenges in the near term for the U.S. and global economy. Even though actual default rates are likely to stay low, risk aversion could still force credit spreads to widen and put pressure on HY bond prices.

As a result, the second consideration will be investors’ sensitivity towards HY bond prices. For those investors who are sensitive to price volatility, they may opt for high quality fixed income in the near term as the economic cycle plays out.

Meanwhile, there are investors who are more focused on income generation over several economic cycles and are willing to tolerate some price swings. Then the current environment is a good starting point to build allocation into HY corporate debt considering the constructive long-term fundamentals of the sector. 

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