Why High Yield Bonds Could Benefit Portfolios in 2024
- Volatility & Risk
- Fixed Income Insights
- High Yield
- Risk Management
In 2024, we expect the U.S. economy to slow, which could spark some volatility in the equity market. As a way to help investors manage portfolio risk while earning income, high yield bonds merit a look. When stock markets slide, high yield bonds historically have outperformed equities on average, similar to the diversification benefits other types of bonds provide. However, strong credit quality, a benign outlook and elevated yields make high yield bonds especially attractive now and potentially enhance those diversification benefits.
The quality of bonds in high yield market has notably increased, as BB- and B-rated issuers comprise 87% of the asset class, above the 20-year average of 83% (Exhibit 1). High yield issuers generally have become larger and more diversified, improving their ability to weather economic adversity. Tight lending standards and elevated interest costs are likely to keep debt level growth low for companies, as debt has become an expensive way to run a business. This helps to keep the leverage, and in turn default risk, from growing substantially. We expect default rates to be range-bound around the long-term average of 3% to 4%.
Default risk is the probability that a bond issuer can't make full and timely payments of contractually obligated principal and interest.
EXHIBIT 1: High Yield Credit Quality at Historically High Level
Compared to its 20-year average, the credit quality of the high yield market was relatively high as of November 2023, with BB- and B-rated issuers comprising 87% of the asset class. This may help limit risk of defaults.
Set Up for Solid Performance
Our outlook should support total return, a combination of price appreciation and yield. We see potential for price appreciation this year because as interest rates fall, which we expect this year, bond prices generally gain. Conversely, prices fall when rates rise. The rising rates of the past two years lowered the prices of high yield bonds, setting them up for notable price appreciation if rates fall this year with expectations of the start of Federal Reserve rate cuts.
In terms of yields, the elevated yields today not only enhance returns, they also historically have correlated with strong future performance within certain ranges, as shown in Exhibit 2. Based on data going back to 2000, high yield bonds with yields of 7% to 8%, the range we’re seeing now, have produced a median return of 7.4% a year later with positive returns 88% of the time. Generally, high yield bonds with yields from 6% to 10% represented the sweet spot for year-forward returns in this analysis.
EXHIBIT 2: The Historical 'Sweet Spot' for Yields
High yield bonds with yields of 7% to 8%, the range we’re seeing now, have produced a median return of 7.4% a year later with positive returns 88% of the time. Generally, high yield bonds with yields from 6% to 10% represented the sweet spot for year-forward returns in this analysis.
The Maturity Wall Risk
A risk that some see looming over the high yield market is the increasing amount of debt maturing for high yield issuers in the coming years, often called a “maturity wall”. When debt comes due, companies usually must refinance the debt by issuing new high yield bonds. Companies that are refinancing debt now usually are paying more interest than the maturing debt issued years ago at much lower rates.
The concern is that the significantly higher interest costs may increase the risk of default. However, we think the higher quality issuers now can absorb higher interest costs, even if rates don’t fall, given their increased scale and ability to deliver productivity gains and earnings growth. If rates fall as we expect this year, the jump in interest costs likely will be less dramatic for companies who refinance after 2024.
An Attractive Market Backdrop
A less hawkish Federal Reserve and improving fundamentals should continue to support the high yield market. Also, a benign default outlook provides an attractive backdrop for elevated yields. Under these market conditions, we think investors can find value in the portfolio diversification benefits of , in particular if equity volatility strikes amid a slowing economy.
Promising Outlook for High Yield
The potential for a slowing economy in 2024 poses challenges for investors. High yield bonds look attractive because of stable fundamentals, a benign default outlook and a history of outperforming stocks when the stock market falls.
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