We recently asked high-yield portfolio managers David Daigle and Shannon Ward and fixed income investment director David Bradin for their perspectives on investing in the high-yield market against the backdrop of rising rates, historically tight spreads and a rebounding economy. We also discussed structural shifts in the asset class, as well as near-term challenges. Below are a few of their observations.

1. Credit quality has improved

The overall credit quality of the high-yield (BB/Ba and below) universe has improved significantly over a long period of time, and more acutely since 2019. Companies rated double-B, the highest rating assigned to a high-yield issuer, now represent more than half the market, up from around one third 20 years ago. On the flip side, triple-C-rated companies made up nearly one-quarter of the market at the height of the financial crisis in 2008–2009 but now account for just 13%.

The opposite holds true for investment-grade bonds. More than half of the market is rated triple-B, the lowest investment-grade rating. Consequently, there are a lot of companies massed around the dividing line between investment grade and high yield. That’s why there are a good number of crossovers: formerly investment-grade issuers — fallen angels — hitting high yield and rising stars moving up to investment grade. This widens the opportunity set for high-yield investors over a full cycle. And it illustrates the narrowing differentiation between the two markets, with high yield improving in quality and investment grade declining.

The COVID-19 crisis created a lot of fallen angels that we never would have had the opportunity to invest in before, because those companies were well ensconced in the investment-grade market. Ford is an example, as well as some of the airlines. These cyclical companies issued bonds with high-yield ratings and many had to pay very high coupons relative to the interest rates they would have had to borrow at in the investment-grade market. This would have made these bonds attractive to high-yield investors who could maintain a long-term perspective

To understand these shifts in credit quality, we like to think of the high-yield market as primarily composed of three kinds of issuers.

A higher quality high-yield market¹

First are the leveraged private equity issuers, who dominated the asset class a decade ago. These companies now prefer to borrow in the leveraged loan market, where borrowing terms and covenants have become increasingly more flexible for issuers. With the absence of these highly leveraged issuers, high yield has become relatively less risky but also lower yielding.

A second set of companies resides in high yield because they have struggled due to poor management or poor governance, and their credit ratings reflect these risks. These can be good investments depending on where high-yield investors fall in the capital structure and the price that they pay for the bonds.

Increasingly, the high-yield market is dominated by a third group of companies: sophisticated users of leverage. In many cases, they are high-yield issuers by choice because they think a double-B or single-B rating is the sweet spot for their financial profile. Many of them may temporarily boost leverage for business reasons, such as increased capital spending, acquisitions or stock buybacks. It’s not unusual for them to migrate between high yield and investment grade.

1 Source: Bloomberg Index Services Ltd. As of 8 April 2021. Figures reflect percentage of US market value. Data excludes debt that is rated below CCC or is unrated. 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

 

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• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.