A Lot of Carry But a Little Wary: Optimizing for Volatility in High Yield Bonds

High inflation, tightening monetary policy, and recession fears have made for tumultuous asset markets in recent months. In the US, while inflation appears to have peaked, the Fed remains focused on reining it in, even at the risk of a softer economy, and quantitative tightening is now at full speed. In Europe, the debate is less about whether the region is facing a recession than how deep the recession will be, and where stagflation scenarios may be in play. The Ukraine war is casting a long shadow and has no clear exit. And in China, the government’s zero-Covid policies are shackling its economy and have been a big drag on both domestic consumption and global growth.

Despite these headwinds, credit fundamentals are still on solid footing, especially in the US – and the challenge for high yield bond investors after a tough first half will be optimizing investments for further volatility.

Earnings are back, and credit quality is strong again

Looking toward the end of 2022 and into 2023, the high yield market is starting from a place of fundamental strength. The past decade has seen shorter credit cycles, with issuers and investors growing more cautious about credit quality. Issuers continue to reduce debt and maintain solid liquidity profiles, and after the Covid-related slowdown, earnings have bounced back past 2019 levels overall (see charts below).

These trends have resulted in a steady improvement in credit quality. Lower-quality CCC rated issuance reached a pre-financial-crisis peak of roughly 22% of the high yield market in July of 2008, based on market value. Currently, CCC rated issuance accounts for only 11% of the high yield market. Meanwhile, higher-quality BB rated issuance currently accounts for 52% of the high yield market, up from 35% in July of 2008.1

High Yield Issuers Have Reduced Their Debt Loads

Issuers’ reported gross and net leverage down 0.7x and 0.8x versus year-end 2019 levels

Source: BofA Global Research, High Yield Credit Chartbook, as of 31 August 2022.

Second-quarter earnings beat expectations overall, with many positive surprises and solid growth, and forward-looking commentary from companies indicates that they have learned to manage higher labor and input costs. Inflation was a major concern at the end of 2021, but has since moved from an unexpected shock and drag on performance to a factor that companies have largely incorporated into their business plans. On the whole, companies have successfully defended their margins to date.

Earnings Growth Is Solid at 40% Year-Over-Year

High yield total debt and LTM EBITDA growth

Source: BofA Global Research, High Yield Credit Chartbook, as of 31 August 2022.

With economic stagnation likely throughout 2023, we believe earnings will deteriorate slightly from current levels, but we view the macro picture as challenging, not dire. Defaults in the high yield market have averaged roughly 4% annually since 2005 (based on par amount).2 Even in a moderate recession scenario, we would not expect corporate default rates to move much above long-term averages, given the improvement in credit quality. The main risk we see for credit spreads does not arise from the asset class itself, but rather from secondary volatility in adjacent asset classes, like equities.

Carry assets with a high income component may offer a buffer against volatility

An environment in which volatility continues to rattle risk markets should favor carry asset classes with a high income component, which can act as a buffer against volatility. Our Capital Market Line (CML) illustrates this point well, with asset classes that lie near the line close to fair value, in our view, and those well above the line deemed attractive and those well below the line deemed unattractive over an intermediate-term perspective (see below). US high yield is attractively positioned on the CML compared with assets such as US intermediate credit, which has much less expected risk but also much lower return potential, as well as private equity, US cyclicals, and US equity financials, which have slightly higher return potential but engender much greater risk. Underpinning our risk outlook is a US economy likely headed for a soft(ish) landing amid continued healthy labor markets and consumption.

High Yield Is Well Positioned on Our Capital Market Line

As of 31 August 2022 (local currency)

As of 31 August 2022. Based on PineBridge Investments’ estimates of forward-looking five-year returns and standard deviation. The Capital Market Line (CML) is not intended to represent the return prospects of any PineBridge products, only the attractiveness of asset class indices, compared across the capital markets. Please see Capital Market Line Endnotes. Note that the CML’s shape and positioning were determined based on the larger categories and do not reflect the subset categories of select asset classes, which are shown relative to other asset classes only.

So far, 2022 has been full of adjustments for investors. The first quarter was characterized by the resetting of interest rates higher as the acute pandemic period neared an end, while the second saw volatility as investors assessed the impact of tightening financial conditions and the war in Ukraine on the economic outlook. The third quarter kicked off with a broad-based risk rally due to healthy labor markets and corporate fundamentals, leaving us with high-yield market option-adjusted spreads (OAS) that appear range-bound in the 400 to 650 basis point area for the foreseeable future (as of 23 September 2022, the OAS was 512 bps).3 The lower bound seems to appropriately discount our lower default risk assumption, while the higher end of the range compensates for a moderate economic slowdown accompanied by relatively full employment compared with prior downturns.

It’s also worth noting that the size of the high yield market has shrunk during 2022.4 A number of rising stars with larger capital structures have been upgraded to investment grade as earnings recover. Additionally, new issuance has been limited, as much of the refinancing supply of prior years has dwindled amid rising interest rates. This has created a positive technical backdrop during risk-on periods: If investors’ risk appetites turn more aggressive, the asset class could benefit substantially from increased demand that pushes bond prices up.

Most high yield sectors are compensating investors appropriately for the related risk, in our view, providing a range of yields in the market. Given the macro headwinds, we currently prefer a slightly defensive, lower-risk stance in the context of a well-diversified portfolio. Although we think credit risk will remain muted, we are more focused on credit quality than on markedly reducing exposure to cyclical sectors. While we believe defaults will be lower than in past recessionary cycles, they will likely occur, as always, among the lower-rated issuers.

High Yield Default Risk Primarily Resides in Lower-Rated Issuers

US high yield issuer default rates by rating

Source: BofA Global Research, High Yield Credit Chartbook, as of 31 August 2022.

With this in mind, we viewed the recent rally as an opportunity to selectively dial back risk within high yield portfolios – specifically triple-C rated debt – and to reduce overweights in more cyclical sectors. On the back of strong performance in July and the first half of August, we favor a reduction in risk positioning relative to the broad high yield market via trimming energy exposure, specifically midstream and exploration and production credits that were trading tighter than the broad high yield market, as well as finance companies and some consumer cyclical segments, such as restaurants, as we expect consumers to feel the pinch from high inflation and tighter financial conditions.

We like certain issuers in defensive sectors, such as health care, media, and packaging. And while we favor risk reduction overall, we see areas of opportunity to retain targeted risks in credits that we believe are adequately compensating investors.

Key investor takeaways

With returns somewhat lackluster across asset classes, we believe we’re in a market where it makes sense to optimize for volatility as much as for return. Credit stands out in this environment, because a higher proportion of returns are stable, coming from coupon income. Since the inception of the Bloomberg Indices in 1983, the high yield market has captured roughly 75% of the total return of the S&P 500 with only 56% of the risk.5 This has resulted in superior risk-adjusted returns, as measured by Sharpe ratios.

Given that the average credit quality of the high yield market has improved and our view that valuations are adequately compensating for the credit risk against a relatively benign default backdrop, we view high yield as an attractive asset class in a diversified portfolio. We also view it favorably relative to other risk asset classes, such as equities, where valuations (as measured by forward price/earnings ratios) are still elevated and price volatility will likely persist.

Positioning for volatility in today’s market means taking targeted risks and keeping overall portfolio risk flexible enough to benefit from periodic price dislocations. To us, this boils down to neutralizing top-level risk and focusing on security selection.

Specifically, we believe some secured bonds issued with high coupons by companies hit hard by the 2020 Covid lockdowns, particularly in the airline segment, have very good return potential.

We also favor energy after seeing a number of rising stars in the segment, and some issuers have used strong free cash flow from higher oil prices to tender for outstanding bonds that were trading at a discount. We expect this trend to continue, although we’re likely at the midpoint of the energy upgrade cycle.

Among issuers that benefited most from Covid reopenings, we remain constructive on select credits in leisure and gaming but less so on restaurants.

And while we generally don’t favor triple-C credits at present, we are seeing select high-cash-flow opportunities, particularly in building materials and software. We continue to avoid the ailing brick-and-mortar retail segment and pharmaceuticals amid strong generic competition.

At the portfolio level, while calculated risks may pay off, we see little reason to be aggressively overweight risk in an environment where we’re looking to optimize for volatility.