Compared to the past decade or so, the yield on high yield corporate bonds currently appears attractive, with yields typically in the range of 6-8%. In fact, yields are trading close to the 20-year average that incorporates the high yields during and surrounding the Global Financial Crisis. A common question we receive, however, when speaking with investors is that while yields are high, is that not just because government bond yields are high, surely credit spreads are near their tights?

JHI

The credit spread is the difference in yield between a corporate bond and a government bond of the same maturity. It is essentially the extra yield that an investor receives for taking on the risk that the corporate bond might default (i.e., fail to meet the interest and principal repayment on the bond). A cursory glance at the credit spread on high yield bonds does suggest that spreads are near their tights (lows), although they are still some way above the lows reached in 2018 and the early 2000s.

Optically, therefore, spreads appear tight, but we think this fails to take into account two factors.

Higher credit quality

First, improved credit quality. BB-rated bonds – the better quality cohort – make up a higher proportion of the high yield bond market than 10 years ago and even more so than 20 years ago. Since investors would demand a higher yield and spread to invest in lower rated bonds (CCC or lower) that are closer to distress, it stands to reason that, all else being equal, an index today with a smaller weight in lower rated bonds ought to have a tighter spread.

Clearly, there are other factors that can affect spread levels. For example, Europe currently trades with wider (higher) spreads than the US, even though its high yield bond market is rated better quality. Reasons for this include the fact that government bond yields are lower in Europe so to attract global capital, spreads are a bit higher. Additionally, it could reflect the relative strengths of the European and US economies, with the weaker European economy leading to investors demanding a little more spread to lend to European companies.

Pull to par

A second factor for tight spreads is the fact that bond prices are trading well below par. It is rare for credit spreads to be tight and bond prices to be so low.

This creates a pull to par effect (bonds typically move towards their par value the closer they get to their maturity date). There is also the prospect of a beneficial effect from early refinancing, which would enhance investor returns. It can be common for bond issuers to issue callable bonds. These are bonds that allow the bond issuer to redeem (call) the bond early.  In an environment of lower yields, an early call would usually be disadvantageous to investors as it would mean investors having to reinvest in bonds with lower coupons (the interest rate paid by the bond). Today, however, yields and coupons are typically higher than they have been for the last few years so investors can often reinvest at a similar or higher coupon.

If we look at Company A you can see the effect an early call has on the yield that an investor would experience. With the bond trading below par, an early call will result in a higher yield, so the worst call date (from a bond investor’s viewpoint) becomes the maturity date. The yield to maturity and yield to worst in this case are therefore identical. The earlier the call, the bigger the impact on the yield as investors benefit from the accelerated capital uplift from receiving par early (plus any coupon prior to the call date).

Why refinance early?

If borrowing rates today are lower than a company’s existing financing costs, there is an obvious incentive for a company to refinance a bond. But why should a bond issuer want to call their bonds early if the coupon would be the same or higher? Why not wait until maturity? Most high yield bonds are typically refinanced at least one year before maturity. There are several reasons why companies tend to move earlier:

• Companies do not want to leave refinancing to the last minute in case they have difficulty rolling over the debt. No one knows exactly what the market environment might be near to the maturity date, for example, capital markets might be closed as happened at the height of the Global Financial Crisis or the recent Covid pandemic. Refinancing earlier gives the company more flexibility.
• Most companies prefer to keep debt sitting within ‘long-term liabilities’ on their balance sheets so that their accounting ratios look better. Debt that must be paid back within 12 months is treated as a ‘current liability’ under accounting treatment, so companies are often keen to refinance debt to avoid it moving into current liability.
• From a signalling perspective, a successful refinancing can help with the market opinion of the company because it removes a near-term risk, potentially helping to protect or improve a company’s credit rating.

Recently, we have seen a drift down in the gap between the index yield and the average coupon. The gap is still positive meaning that refinancing rates are still typically in excess of existing coupons but the potential change in coupon feels a lot more palatable to companies than it was a year ago.

Some companies have held off refinancing since 2022, hoping that rate cuts would commence. But with the clock ticking down to maturities in the next couple of years, many will call early to avoid the debt becoming current liabilities.

Substitution effect

Over the next 12-18 months a substitution effect should, therefore, be taking place in the high yield index as bond issuers like Company A refinance their existing bonds. This will lead to a higher spread as bonds with lower coupons are replaced.

Spreads therefore appear tight, but we see this as an artificial level. As bonds are called and refinanced, we should see a rise in spreads. By being selective we can seek to capture the uplift by identifying these bonds.

IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk.  The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.