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.


Read important investment disclosures

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.


Read all perspectives on bond markets

EXPLORE NOW
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. 

Additional perspectives

Figures shown are past results and are not predictive of results in future periods. Current and future results may be lower or higher than those shown. Investing for short periods makes losses more likely. Prices and returns will vary, so investors may lose money. View mutual fund expense ratios and returns.
Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.
Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.
Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness.
The use of derivatives involves a variety of risks, which may be different from, or greater than, the risks associated with investing in traditional securities, such as stocks and bonds.
Lower rated bonds are subject to greater fluctuations in value and risk of loss of income and principal than higher rated bonds.
The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings.
Investing outside the United States involves risks, such as currency fluctuations, periods of illiquidity and price volatility. These risks may be heightened in connection with investments in developing countries.
There have been periods when the results lagged the index(es) and/or average(s). The indexes are unmanaged and, therefore, have no expenses. Investors cannot invest directly in an index.
This report, and any product, index or fund referred to herein, is not sponsored, endorsed or promoted in any way by J.P. Morgan or any of its affiliates who provide no warranties whatsoever, express or implied, and shall have no liability to any prospective investor, in connection with this report. J.P. Morgan disclaimer: https://www.jpmm.com/research/disclosures
Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.
All Capital Group trademarks mentioned are owned by The Capital Group Companies, Inc., an affiliated company or fund. All other company and product names mentioned are the property of their respective companies.
Investment results assume all distributions are reinvested and reflect applicable fees and expenses.
When applicable, results reflect fee waivers and/or expense reimbursements, without which they would have been lower and net expenses higher. Please refer to capitalgroup.com for more information. Read details about how waivers and/or reimbursements affect the results for each fund. View results and yields without fee waiver and/or expense reimbursement.
For the American High-Income Trust share class(es) listed below, the investment adviser has agreed to waive a portion of fund expenses through the date(s) listed below, without which results would have been lower and net expenses higher.
  • Class F-2 shares (expiration: 12/1/2024)
The investment adviser may elect at its discretion to extend, modify or terminate the waiver as of any noted expiration date.
Certain share classes were offered after the inception dates of some funds. Results for these shares prior to the dates of first sale are hypothetical based on the original share class results without a sales charge, adjusted for typical estimated expenses. 
  • Class F-2 shares were first offered on 8/1/2008.
Results for certain funds with an inception date after the share class inception also include hypothetical returns because those funds' shares sold after the funds' date of first offering. View dates of first sale and specific expense adjustment information.
Use of this website is intended for U.S. residents only.
Effective July 1, 2024, American Funds Distributors, Inc. was renamed Capital Client Group, Inc.
This content, developed by Capital Group, home of American Funds, should not be used as a primary basis for investment decisions and is not intended to serve as impartial investment or fiduciary advice.
© 2024 Morningstar, Inc. All Rights Reserved. Some of the information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar, its content providers nor Capital Group are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Information is calculated by Morningstar. Due to differing calculation methods, the figures shown here may differ from those calculated by Capital Group.

Bloomberg U.S. Aggregate Index represents the U.S. investment-grade fixed-rate bond market.

Bloomberg U.S. Corporate High Yield 2% Issuer Capped Index covers the universe of fixed-rate, non-investment grade debt. The index limits the maximum exposure of any one issuer to 2%.

Yields referenced are yield to worst. Yield to worst is the lowest yield that can be realized by either calling or putting on one of the available call/put dates, or holding a bond to maturity.