Knowledge. Shared Blog

October 2020

The Outlook for Global High-Yield Bonds

Tom Ross, corporate credit manager, discusses conditions in the high-yield market, including the default outlook, the importance of monetary and fiscal stimulus, and whether high yield can tolerate inflation.

Key Takeaways

  • Current high-yield bond spreads reflect the expectation of higher default rates. Even so, expectations have moderated since the sell-off in March as economic growth has stabilized.
  • Central banks have supported the high-yield market through direct purchases of corporate bonds and by providing liquidity to facilitate corporate refinancing. Low policy rates also indirectly support the high-yield market by creating greater demand for yield.
  • In our view, a potential uptick in inflation is less of a concern, as credit spreads in the high-yield market offer some cushion against rising government bond yields and rising prices can be good for corporate revenues.
View Transcript

How has high yield performed through the COVID crisis?

Tom Ross: High-yield markets are sensitive to economic activity, so as you’d expect during the COVID crisis, prices fell and spreads widened significantly. Since March, we’ve then seen a retracement in spreads, such that returns have actually ended up to be roughly neutral on the year, but spreads still remain wider than at the start of the year, creating an opportunity going forward.

Are high-yield investors being compensated for defaults?

One of the reasons spreads are slightly wider than at the start of the year is because they are compensating for an increased level of defaults within the market. Now, the expectation if we went back to March for default rates was that they were going to go significantly higher. But since then, the monetary stimulus and the fiscal stimulus has really ensured that those default rates, whilst being higher this year, won’t be anything like the expectations back in March in the depths of the COVID crisis.

Can high-yield issuers support higher borrowings?

High-yield issuers absolutely had to take on a greater debt burden to bridge that economic shock that we had because of the COVID crisis. What we’re looking for now is those companies that are looking to effectively be in balance sheet repair mode; what you would typically expect in the early part of a credit cycle, as they now look to use those revenues in a slightly improving growth scenario in order to get that level of debt back down to similar levels that they had pre-crisis.

How important is monetary and fiscal stimulus?

Monetary and fiscal stimulus have been so important throughout this crisis. If we just take monetary to start, it’s almost had a threefold impact on markets. The direct impact of purchases, especially within the investment-grade market, but also now within the high-yield market, especially from the Federal Reserve. We also have the case that government bond rates globally are now so low that that grab for yield is really being fueled by that monetary stimulus. And then also it’s the fact that that monetary stimulus really allowed the credit markets, the high-yield market, to reopen and issue bonds, to provide financing, to bridge that economic shock. Fiscal stimulus has also been key because obviously the consumer was so badly hit by the lockdowns that were imposed across many countries, that that fiscal stimulus ensured that the consumer is in a much better place than it would have been relative to any other crisis we’ve had.

Can high yield tolerate higher inflation?

High yield can tolerate higher inflation and tends to perform fairly well in those market environments. That’s partly because of the extra spread cushion that high yield has relative to the underlying government bonds that are more sensitive to increased inflation. But also because high yield companies tend to perform fairly well in periods where prices are rising. The potential risk of higher inflation is if it is going to cause an early withdrawal from monetary and fiscal stimulus. However, if we look at the [U.S. Federal Reserve] Fed’s recent policy shift, it seems quite clear that they are willing to tolerate higher inflation and are more concerned about the Japanese experience of deflation.

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