Strong tailwinds for high yield but ride may be bumpy
A strengthening economy should smooth rising-rate headwinds.
This month’s sell-off in U.S. Treasuries has had a ripple effect throughout the markets and high yield is no exception. For example, while high-yield returns as measured by the Bloomberg Barclays US Corporate High Yield 2% Issuer Capped Index were slightly positive in January and February, returns through the first three weeks of March turned year-to-date returns slightly negative. Nonetheless, they remained well ahead of the year-to-date return of the broader, higher-quality Bloomberg Barclays US Aggregate Index.
This is typical of high yield’s defensive stance in most rising-rate environments. There’s a simple explanation. Rates typically rise when the economy is doing well, corporate profits are improving and default rates are declining. While these conditions tend to lead to higher U.S. Treasury yields, they also result in much improved corporate credit quality. As a result, the difference, or spread, between yields on U.S. Treasuries and comparable maturity high-yield bonds typically narrows, offsetting the rise in rates. Also, it’s not unusual to see ratings upgrades, bond calls and tenders, merger and acquisitions and equity initial public offerings in an improving economy—all further benefitting high yield.
Adding to high yield’s positives are its higher-income returns and lower duration risk relative to many other fixed-income asset classes. Compare, for example, high yield’s 4.26% yield-to-worst—its lowest possible yield—relative to that of the Bloomberg Barclays indexes at the end of February: 2.05% for the high-quality Bloomberg Barclays US Corporate Bond Index and 1.42% for the aggregate. Meanwhile, high yield’s duration was 3.7 years versus 8.5 years for the high-quality corporate index and 6.42 for the aggregate.
Within the high-yield benchmark, CCC-rated securities continue to lead the way with a year-to-date return of 3.03%, and this understates the impact of the lower-quality sectors. The real action continues to be in the semi-distressed—particularly Energy-related—sectors. Looking ahead, we believe the key determinant for high yield will be based on how much spread tightening can absorb rate increases. High-yield credit spreads currently are at 436 basis points, and we believe they can narrow into the mid-300s if the economy is as strong as we think it will be in 2021. This level of spread tightening would provide a substantial amount of rate-increase protection.
With that said, there may be bumps along the way as technical factors, driven by mutual fund flows and investor psychology, take over for short periods. But our experience indicates that over the long term, the relative return differential between high yield and high quality tends to reflect economic conditions. That’s why the Federated Hermes fixed-income sector committee continues to recommend an overweight allocation to high yield.