Case for high yield sharpens as severe recession fears fade
David Bradin
Fixed Income Investment Director
Chris Lin
Investment Product Manager
KEY TAKEAWAYS
  • High-yield bond spreads may not reach levels sought by some investors.
  • Despite appearing average, current high-yield spreads are already pricing in some market distress and expected losses.
  • Even in a recession, strong yields have potential to help high-yield bonds generate positive returns.
  • Adding American High-Income Trust® to a portfolio has had the potential to increase total return without adding material volatility.

As recessionary clouds form, high-yield bonds are out — or so some investors seem to think. But those waiting for a better time to allocate to high-yield bonds could be in for a rude awakening: The opportunity for markedly stronger yields over Treasuries may not materialize.


One widely followed high-yield bond index, the Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index, was yielding 8.53% as of June 30, 2023. Its spread, or the difference in yield investors are paid over Treasuries, was 3.92%. This is often referred to as “392 basis points” (bps).


Some investors may be waiting for high-yield spreads to increase to a range of 800 bps to 1,000 bps before they invest. But over the last 20 years, those very high levels of investor compensation have only occurred during extremely stressed market conditions and for mostly brief periods. Spreads may not widen as much as some anticipate for several reasons, including the current near-all-time high for the high-yield market’s credit quality. Also, with predictions of an economic downturn rampant for over a year now, many companies have moved proactively, taking steps to help offset the negative impact of a slowdown.


If spreads do substantially widen, that would be considered an outlier scenario and signal a historical buying opportunity.


The bar chart is titled, “High yield spreads are rarely above 800 basis points.” The chart callout is titled, “Spreads above 800 occurred during extreme market conditions and were relatively brief” The bar chart shows four periods when spreads for high yield, represented by the Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index, have been above 800 basis points, which is shown as a purple line. The four times this occurred since 2007 are the Global Financial Crisis from 2007 to 2010, when spreads were over 800 basis points for 228 days, with a maximum of 1,937 basis points. For the U.S. Downgrade in 2011, spreads were above 800 basis points for 7 days, with a maximum of 878 basis points. For the energy crisis in 2016, spreads were over 800 basis points for 6 days, with a maximum of 839 basis points. For the Covid-19 pandemic in 2020, spreads were above 800 basis points for 18 days, with a maximum of 1,100 basis points.

Sources: Capital Group, Bloomberg. As of 6/30/23. Periods shown are from 2007 to 6/30/23. Past results are not predictive of future periods. The option-adjusted spread (OAS) is the difference between the yield of a security and Treasury rates, adjusted for embedded options. High-yield spreads are represented by the Bloomberg U.S. High Yield 2% Issuer Capped Index option-adjusted spread.

This time really could be different. Here’s why:


1. Today’s spreads largely account for potential risks


High-yield spreads of 450 bps to 500 bps are in line with the 20-year average of the high-yield index, but a deeper dive indicates those levels may account for risks typically tied to a downturn.


The high-yield market’s credit quality is near the highest it has been over this two-decade period, based on ratings data from Standard & Poor’s and Moody’s. Nearly half of the high-yield universe has the highest rating of BB/Ba, a 30% improvement from 2007’s level. Meanwhile, companies with the lowest credit quality (CCC/Caa and below) make up just 12% of high-yield bonds today versus the pre-global financial crisis figure of 19%. Current spreads reflect this improved credit quality. If today’s high-yield universe had a similar credit profile to 2007, spreads would likely be around 500 bps to 575 bps, or above the 20-year average, indicating a modest amount of negative market sentiment.


2. Defaults will likely increase, but from historically low levels


The premium investors pay over Treasuries to hold high-yield bonds compensates investors for perceived credit risk, including the risk of default. Specifically, credit valuations (i.e., the fair value of an investment) can account for a worsening credit risk profile as the price of the bond will decline and the spread will widen. As such, spreads are a good forward indicator of credit losses, and historically, defaults peaked about 12 months after spreads peaked.


Current spreads indicate that investors expect defaults to increase to 3% over the next year from 2022’s historically low levels, according to J.P. Morgan. This expected 3% default rate is consistent with the 30-year average default rate for the high-yield market. Defaults may not reach levels of past default cycles in part because of the COVID-19 recession. That sharp recession pulled forward defaults of issuers susceptible to future default, leaving the sector with stronger issuers with the potential to better sustain the next recession.


3. Even in a down market, high-yield returns still have potential to be positive


Consider the Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index. At a June 30, 2023 yield to worst of around 8.5%, the likelihood of substantial losses when investing in that sector may be low.


A recession would likely have a negative impact on high-yield bond prices, and consequently total return. We believe spreads would widen by around 200 bps in a downturn, which translates to a 7% price loss, effectively wiping out most of the coupon, or interest payments, received on a bond. That figure assumes the index’s spread duration of 3.5 years, which measures the impact of credit risk on price return.


But that isn’t the end of the story. In such a recessionary scenario, it’s highly likely that U.S. Treasury rates would begin to fall. This is because a downturn may lead investors to seek safety in high quality bonds, and the U.S. Federal Reserve may cut the federal funds rate. We believe Treasury yields could fall across the curve around 100 bps in this scenario. As Treasury yields decline, bond prices, including those of high-yield bonds, rise. In this case, the index’s interest rate duration, which measures the impact of interest rate risk on price return, of 3.5 years would lead to a 3.5% positive price impact, raising total return close to 4%, after considering the impacts of coupon payments and spread widening. Even with a potential 2% loss in principal due to defaults creeping up, in this recessionary hypothetical, there could still be a net 3% total return.


The chart is titled, “Even in recession, high-yield returns may be positive.” The chart callout includes index statistics (as of 6/30/23) of yield to worst of 8.5%, spread duration of 3.5 years and interest rate duration of 3.5 years. The chart callout also includes a recession scenario, if spreads widen by 200 bps with a default loss of 2% and interest rates decline 100 bps. In the accompanying graphic, gains are represented by the color green while purple represents losses. The graphic includes a coupon return gain of 8.5% (8.5 green bars), loss from widening credit spreads 7.0% (7 purple bars), loss from defaults 2.0% (2 purple bars), gain from falling interest rates 3.5% (3.5 green bars) and net return gain of 3.0% (3 green bars).

Sources: Capital Group, Bloomberg Index Services, Ltd. For illustrative purposes only. Hypothetical scenario reflects analysis of the authors as of 6/30/23 and is not predictive of future outcomes. The Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index was used as the high-yield sector proxy. The option-adjusted spread (OAS) is the difference between the yield of a security and Treasury rates, adjusted for embedded options. Spread duration indicates a bond fund’s sensitivity to credit spread movements. Interest rate duration indicates a bond fund’s sensitivity to interest rate movements; higher duration indicates more sensitivity. For simplicity, interest rates are assumed to move 100 basis points lower uniformly across the yield curve. Gains or losses from spread and interest rate movement are calculated by multiplying the duration and the change in spread or interest rate. Default assumption based on a 3% default rate with 33% recovery (+1%) for a net default loss of 2%. Values rounded to the nearest 0.5%. 

Current yields offer opportunities to implement high-yield bonds in a portfolio


Today’s elevated yields provide investors with opportunities to implement fixed income, including high yield, into a portfolio.


Investors can aim to achieve enhanced income with high-yield bonds. Over the last 20 years, the average yield on high-yield bonds was 4.4% (440 bps) over core bonds, represented by the Bloomberg U.S. Aggregate Index.


The chart is titled, “High-yield bonds have offered a healthy income potential advantage.” The chart illustrates the average yield to worst over 20 years of two benchmarks. The Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index had a yield to worst of 7.6%. The Bloomberg U.S. Aggregate Index, representative of the broad bond market, had a yield to worst of 3.20%. The Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index delivered a 440 basis point average yield advantage compared to the broad bond index.

Source: Bloomberg. As of 12/31/22. 

Consider a historical hypothetical example that adds a little high yield to a core fixed income allocation. American High-Income Trust aims for returns above its benchmark, the Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index. Many investors use the portfolio alongside The Bond Fund of America®, our flagship core bond fund. It aims for higher returns than its benchmark, the Bloomberg U.S. Aggregate Index with similar equity diversification benefits. Over the past 10 years, an 80% allocation to The Bond Fund of America and 20% allocation to American High-Income Trust had a significantly higher return than the Bloomberg U.S. Aggregate Bond Index. And that higher return came with only marginal added risk, as measured by standard deviation.


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The chart is titled, “Adding some high yield would have boosted returns, with minimal added risk.” The chart callout is titled, “A combination of ABNFX with AHIFX has produced a stronger return without a significant increase to volatility” The y axis is the 10-year average annual return, with “higher return” at the top; the x-axis is standard deviation percentage, with “higher risk” at the far right. The chart illustrates returns of an 80% allocation to The Bond Fund of America F-2 and 20% allocation to American High-Income Trust F-2 (labeled Blended fund portfolio), the Bloomberg U.S. Aggregate Index (labeled Index), and 80% Bloomberg U.S. Aggregate Index and 20% Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index (labeled Blended index) over a 10-year period. The Blended fund portfolio return was 2.42% versus the Index of 1.52% and the Blended index of 2.13%. The standard deviation for the Blended fund portfolio was 4.28, versus the Index of 4.30 and the Blended index of 4.32.

Sources: Morningstar and Bloomberg. As of 12/31/22. Past results are not predictive of future returns. Annualized standard deviation (based on monthly returns) is a common measure of absolute volatility that tells how returns over time have varied from the mean. A lower number signifies lower volatility.

Today’s higher starting yields have also lifted the return expectation for high-yield bonds, as their income component has historically driven total returns. That extra income cushion can help investors navigate an uncertain environment with a return stream that could also be less volatile compared to periods when yields are much lower and price volatility could have an outsized impact. Investors may want to consider adding high-yield bonds to their portfolios during this market opportunity.


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Published on August 9, 2023

David Bradin is a fixed income investment director. He has 18 years of industry experience (as of 12/31/2023). He holds an MBA from Wake Forest University and a bachelor's degree in mediated communications from North Carolina State University.

Chris H. Lin is an investment product manager with 20 years of industry experience (as of 12/31/2023). He holds a bachelor's degree in economics from University of California, Berkeley. 

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