High-yield bonds have become an increasingly popular investment choice, and we strongly believe this asset class is positioned to continue delivering the strong performance seen in the first half of 2024. At Northern Trust Asset Management, we classify high-yield bonds as “the least risky risk asset” because they historically have delivered equity like returns without equity like volatility over the full market cycle thanks in part to their income component. The asset class has grown from $500 billion in 2002 to more than $1.5 trillion today. Inflows of $6.7 billion in May 2024 alone highlight substantial positive sentiment among investors.

Sources: Nasdaq and Bloomberg May 31, 2024

A Compelling Thesis

This favorable trend is rooted in a notable confluence of solid fundamentals, low default risk, and strong performance relative to equities in volatile markets. In addition to their capacity as a yield-producing mainstay, high-yield bonds can help investors optimize portfolio diversification given their resilience during periods of equity decline. The asymmetrical return profile of high yield, when compared to equities (shown below), demonstrates the capture of a considerable portion of positive market gains but only a limited portion of equities’ downside volatility.

Strong Fundamentals Fuel Investor Appetite

Today’s high-yield market offers higher credit quality than a decade ago, a consequence of the improved fundamentals which further support the case for a lower expectation of defaults vs historical averages. As of June 30, 2024, more than half of the high-yield market (51%) consisted of BB-rated bonds (up from 41% 10 years ago), with 37% B-rated, and 11% CCC-rated bonds (compared to 41% and 17% respectively 10 years ago. Furthermore, the size of the market, regarding the number of bonds in the high-yield universe, is at an all-time high. As mentioned previously, the US high-yield bond market represents a more than $1.5 trillion market - up from $500 billion in 2002.

The Portion of the Market in Distress is Low

While rates on high-yield bonds are high, we expect default rates to be low.  Some investors, particularly those who may be new to the high-yield space, may assume that a high interest rate would lead to much higher default rates. This is not the case. As a consequence of these strong fundamentals and strong corporate balance sheets, the high-yield market’s default outlook is notably benign. Eric Williams, portfolio manager and head of capital structure, global fixed income at Northern Trust Asset Management  says: "Treasurers continue to make tremendous progress in pushing out their maturity profile, thereby reducing near-term risks. In general, markets are open for most companies, and as a result, distress remains low, which translates into limited prospects for an increased future default rate."

Further to this supportive environment of low default rates and opportunity for volatility in equity markets, we believe high yield presents a compelling case for strong risk-adjusted total returns for those investors able to allocate. Williams, adds:

"High yield spreads have exhibited a very low level of volatility on a year to date basis and frankly reside at the tighter end of the spread range over the last couple of years. At the aggregate level, many investors may be curious as to the opportunity set available to them with all-in spreads hovering around 300 basis points. Given the outperformance of the asset class relative to other assets, it is clear that the consistent income generation that it affords is a major influence on investors. Currently the yield to worst is north of 8% and there is a 10-point discount relative to par — both have been overriding factors in investors’ decisions to allocate to the asset class."

Higher Interest Coverage & Lower Leverage in the High-Yield Market

Interest coverage ratios^* remain strong thanks to stronger earnings that look set to continue (5-5.75% in 2023), with leverage remaining well below historic peaks since 2011. Only 12% of the high-yield universe has debt maturing in the next two years. "Approximately 40% of debt maturing between 2024 and 2026 has been refinanced over the last year," says Williams. "This has been the most rapid debt extension in history, providing attractive opportunities for investors to capture potential returns."

Sticky Inflation and a Data Dependent Fed

The Federal Reserve ("the Fed") recently noted that its effort to curb inflation is making incremental progress but opted to hold rates at its June meeting. At Northern Trust, we are aligned with the market view and expect two rate cuts by the end of 2024, further supporting the attractiveness of high-yield investments. Anwiti Bahuguna, NTAM’s CIO of global asset allocation notes, "The market has been pricing out expectations of several rate cuts throughout the year as inflation has been sticky. If inflation does not show meaningful signs of falling, we could even see its resurgence, essentially pricing out the two expected cuts. In this scenario, the economic growth we expect might not be enough to balance higher rates. This of course has implications for stock markets and risk assets," she adds.

S&P earnings in 2024 are expected to surpass the average growth rate of the past decade. Bahuguna says, “Earnings expectations are now following the path of United States growth. Consensus now expects S&P earnings to be up 11% this year. It is our view that growth will not only be solid, but it may actually exceed that consensus.”

The era of ultra- low interest rates which, coupled with improved fiscal responsibility, allowed corporate bond issuers to shore up their balance sheets. As a result, their ability to cover interest with earnings is strong, and debt accumulation by companies is restrained, potentially helping to avoid defaults or mitigate losses if default does occur. The markets are welcoming for issuers looking to term out their debt, and there is little near-term need for refinancing by the more vulnerable issuers. Meanwhile, strong U.S. nominal growth supports a stable economic backdrop, allowing investors to explore opportunities with strategic security selection and practical portfolio construction.

The conditions described above make a compelling case for including a high-yield allocation in investor portfolios. The attraction of high yields and potential for strong total returns, coupled with lower volatility compared to other risk assets, remains significant.