One of the best trades to put on in the aftermath of the financial crisis was going long high yield. Spreads blew out to nearly 18% in November 2008, implying a default rate of almost 30%. Looking back, this is far from what actually materialized, as default rates on U.S. high yield peaked at a level of 11% in November of the following year. With the Federal Reserve (Fed) becoming increasingly active in credit markets, we have been getting more and more questions on the outlook for high yield; the bottom line is that while valuations are not terribly compelling, the near-term path for credit spreads may be tighter.

Starting with the fundamentals – the sector composition of the high yield market is somewhat unfavorable given the nature of this lockdown. Nearly 36% of the index is directly exposed to the consumer, and another 10% is energy. With consumers and oil prices both under pressure, the orientation of the high yield market towards these sectors is clearly a risk.

Turning to valuation, if one assumes an average recovery rate of 40%, current spreads of around 6.5% imply a default rate close to 11%. That said, recovery rates are currently at their lowest levels on record, and we would be surprised to see them align with their long-run average going forward. If one assumes a recovery rate that is half of what we have seen on average, the implied default rate falls to about 8%, which is generally in line with our expectations. As such, high yield doesn’t look wildly expensive, but at the same time, the asset class is far from being on sale.

However, it is important to recognize the impact the Fed has had on credit markets; Jay Powell was able to drive a significant rally in spread product by simply stating that the Fed would be setting up corporate credit facilities back in March. On March 23^rd, the index weight of those bonds in the J.P. Morgan Developed Market High Yield Index trading below 60 USD was about 6%; since then it has fallen to about 1.7%. At the same time, issuance across the credit spectrum has been met with robust demand, as historically low risk-free rates have reinvigorated the search for income. With equity markets likely volatile but range bound for the foreseeable future, and Fed rhetoric suggesting policy makers will remain accommodative, high yield bonds are beginning to look attractive on a risk-adjusted basis.

Default rate and spread to worst

Percent

Source: J.P. Morgan Global Economic Research, J.P. Morgan Asset Management.
Default rates are defined as the par value percentage of the total market trading at or below 50% of par value and include any Chapter 11 filing, prepackaged filing or missed interest payments. Spread to worst indicated are the difference between the yield-to-worst of a bond and yield-to-worst of a U.S. Treasury security with a similar duration. High yield is represented by the J.P. Morgan Domestic High Yield Index. Guide to the Markets – U.S. Data are as of June 22, 2020.