The doubling of yields in the global high-yield market over the past 12 months could open a window of opportunity for investors, as Sau Mui and Mark Miller explain.
Read this article to understand:
- Why the carry from high-yield bonds should cushion investors against defaults and further yield widening
- How global high yield has typically enjoyed double-digit outperformance when yields have hit elevated levels previously
- Why the improved credit quality of the global high-yield universe should provide additional comfort to investors
The days of bondholders physically tearing off or clipping their bond coupons to collect interest payments are long gone, but the benefits of receiving regular coupon payments endure. Coupon income — also known as carry — is a crucial element in a bond’s total return.
The power of carry is perhaps most evident in high yield, where relatively high coupon payments underpin the long-term performance of the asset class. We believe the combination of high coupons and currently outsized yields make a strong case for an allocation to global high yield in 2023.
Last year’s aggressive rate hikes by central banks hit many markets hard, not least high yield: 2022 was the second-worst year on record for the asset class. However, the frequency and magnitude of interest-rate rises have transformed the yield environment.
The yield-to-worst — a measure of the lowest possible yield that can be received from owning a bond — of US high yield was 4.25 per cent entering 2022. It has since almost doubled, standing at just over eight per cent at the end of January.1 The situation in Europe is even more remarkable: the yield-to-worst has more than doubled, from below three per cent to around 7.2 per cent, in part due to the benefits of currency hedging.2
Cushioned against risks
High-yield investors face two main risks: losses from defaults and price falls caused by widening yields, the latter due to an increase in the risk-free rate or widening credit spreads as investors fret over the economic outlook and shun risk assets, or a combination of the two. Our analysis suggests today’s yields of around eight per cent provide bondholders with more than adequate compensation for these risks, as we set out below.
Figure 1 details current total return breakeven rates in global high yield over a 12-month period. This shows how far default rates (assuming a 40 per cent recovery rate) and yields must move before total returns turn negative. If we assume a zero-default rate, we can see yields widen by almost 200 basis points (bps) from current levels before the asset class starts generating negative total returns.
Of course, the assumption of zero defaults is unrealistic, but it highlights the power of carry.
Yields can widen by almost 200bps from current levels before the asset class starts generating negative total returns
The high-yield market has experienced historically low default rates in the past 12 months. If one assumes default rates normalise over the next year, rising to their long-term average of four per cent, the breakeven yield movement drops to 125bps. Yields would have to increase from around eight per cent today to 9.25 per cent in the next 12 months before investors begin to receive negative total returns.
Although such a move is possible, the index’s yield has only twice breached nine per cent in the past decade. In summary, the asset class’s high carry provides a sizeable cushion against potential yield widening, even if defaults pick up from current levels.
Figure 1: 12-month total return breakeven analysis for all-maturities global high yield
Note: Based on the Bloomberg Global High Yield Excl CMBS & EMG 2% Cap Index.
Source: Aviva Investors. Data as of January 12, 2023
Figure 2: Long-term average default rate of global high yield (per cent)
Source: Moody’s Investors Service. Data as of December 31, 2023
The cushion provided by carry is even more pronounced for short-duration global high yield.3 Figure 3 highlights the total return breakeven yield movement for the relevant index. Assuming no defaults, the index can withstand 250bps of yield widening before total returns turn negative. This higher figure is due to the shorter duration of the index and slightly higher yield relative to all-maturities high yield.
Carry provides a sufficient cushion to absorb the adverse impacts of a realistic default rate and material yield widening from current levels
Again, assuming a more realistic three to four per cent default rate and 40 per cent recovery rate, the breakeven yield movement is 150-175bps. The index’s yield would need to increase from around eight per cent today to almost ten per cent before total returns turn negative over a 12-month period.
Once more, carry provides a sufficient cushion to absorb the adverse impacts of a realistic default rate and material yield widening from current levels.
Figure 3: Breakevens for short-duration global high-yield
Note: Based on the Global High Yield Excl CMBS & EMG 2% Cap 1-5 Years index.
Source: Aviva Investors. Data as of January 12, 2023
Optimism on defaults
Our analysis hinges on default and recovery rate assumptions. Higher default rates — significantly above our four per cent projection and the long-term average — and lower recovery rates — significantly below the 40 per cent historical average — would challenge our argument.
However, we see a strong case for defaults remaining benign. As we explored in our recent article Focus on the fundamentals, high-yield issuers largely entered 2023 from a position of strength. Additionally, there have been significant structural enhancements in the global high-yield market. These reinforce our view defaults will not climb to abnormally high levels anytime soon.
Furthermore, the convexity of the market has improved. With the global high-yield index price currently around US$89 and a larger share of secured bonds in the index today, as detailed below, loss-given-default — estimated losses from defaults — will be lower, assuming recovery rates remain in line with historical averages.
Turning to the structural improvements referenced above, credit quality in the global high-yield universe is higher than in 2008 and 2015 (see Figure 4), two of the most significant drawdowns the high-yield market has experienced in the past two decades.
Figure 4: Improving credit quality within global high yield
Note: Index shown is Bloomberg Global High Yield xEM xCMBS 2% Issuer Cap Index.
Source: Aviva Investors, Bloomberg. Data as of December 31, 2022
Higher-quality BB-rated bonds — where average default rates are typically around one per cent — now constitute over half of the universe. Meanwhile, the CCC-rated portion — where default rates are typically closer to 17 per cent — has fallen to less than ten per cent.
This improvement in credit quality is partly attributable to COVID-19, when many investment-grade issuers were downgraded to high-yield status in distressed market conditions. Around two-thirds of these fallen angels have since regained investment-grade ratings. However, many fundamentally robust, well-managed former investment-grade companies remain in the high-yield universe. This has increased the concentration of better-quality issuers.
Many issuers also took advantage of abundant liquidity in the years leading up to 2022 to strengthen balance sheets and extend maturities. Refinancing accounted for 60 per cent of high-yield issuance in 2021. This compares favourably to 2007, when over half of issuance funded riskier corporate activity.
Regionally, the European market particularly reflects this shift. It has a greater concentration of BB-rated issuers than the US, which we expect to translate to lower defaults. Regional differences underline why a global approach can help drive outperformance.
As for recovery rates, secured bonds now constitute around one-quarter of the global high-yield market. The recovery rate for secured bonds is closer to 60 per cent rather than the typical 40 per cent recovery rate for regular high-yield bonds. The growth of this part of the market is positive for investors worried about loss-given-defaults.
Outsized returns after previous yield spikes
While past performance is never a guarantee of future results, it can be illustrative to review how global high yield performed in the wake of previous spikes when yields-to-worst hit eight per cent.
Figure 5: Global high-yield 12-month returns after yields-to-worst hit eight per cent
Source: Bloomberg. Data as of January 24, 2023
As Figure 5 shows, over the 12-year period from December 2010 to December 2022, the asset class delivered double-digit 12-month trailing returns on three of the four occasions when yields-to-worst first hit eight per cent in a drawdown.4 We believe it is reasonable to assume a similar pattern may occur again after last year’s drawdown.
After a tough 2022, investors may want to look afresh at global high yield:
- Carry, provided by high coupons, currently constitutes a sizeable cushion to bear the impact of a material widening in yields and increase in the default rate
- Historically, the asset class has performed strongly in 12-month periods immediately after yields-to-worst hit eight per cent, the level they rose to in the second half of 2022
- Given improved credit quality in the asset class, we believe defaults will remain modest and should not exceed their four per cent long-term average, despite the weak short-term economic outlook