High Yield Is Outperforming, But for How Long?

One of 2022’s big surprises was how well high yield (HY) credit spreads performed despite the elevated volatility and bruising returns suffered by most other asset classes. (HY is a higher-risk subset of corporate bonds conventionally quoted by the difference in yield relative to a comparable Treasury bond maturity.)

Over the year, as the economy showed signs of slackening一due to the Federal Open Market Committee (Fed) rate hikes一HY credit spreads have maintained levels below the 700 to 1,000 basis points typically seen during slower economic growth periods.

As we move into 2023, the trend appears to be continuing. Despite the Fed’s ongoing hawkish stance一and increasing probability of recession一HY spreads remain unusually tight at 400+ basis points and appear stable within this range, for now.

HY Risk Increases with a Slowing Economy

By nature, HY contains more risk due to the relative financial instability of its constituent issuers. Indeed, credit risk can come from several factors, such as excessive leverage, high fixed costs, lack of liquidity, or an unproven business model.

And while a declining economic environment can be challenging for any company, those with existing financial weaknesses are more susceptible to its adverse effects.

Thus, in today's slow growth conditions, we would expect to see more evidence of credit risk in current HY spreads.

How the sector will ultimately perform, however, will depend on future economic conditions.

If economic growth stabilizes or expands, HY could be well-positioned to gain. Under a soft-landing scenario一which will include ongoing declines in growth一HY could benefit from eventual rate cuts一but widening credit spreads could dampen these returns.

Finally, if we’re in for a recession, HY credit spreads could be especially vulnerable at their current levels.

So Why is High Yield Outperforming?

The ongoing rally in HY is partly due to non-credit-related factors, such as strong investor demand for yield and exposure to record gains in the energy sector. In addition, spreads may be slightly tighter due to companies benefitting from the last 15 years of historically low interest rates. Not only have borrowing rates been cheaper, but the refinancing of older, higher-costing debt has helped decrease the risk of default in the sector.

Some of these effects are illustrated in the two graphs below.

The first graph illustrates the percentage of U.S. HY corporate bond yields that are attributable to credit spreads. The current level of 51% is the lowest it's been since 2018. Said another way, investors are taking on more risk to obtain the yield earned within the asset class.

Next, the yield-to-worst (YTW) graph below illustrates the average minimum absolute yield an investor could expect to receive (on HY), assuming the issuer doesn’t default on its payment obligations. Indeed, the current 8.1% rate is well above the 10+ year average of 6.17% and is likely a significant driver of HY demand.

More Economic Trouble Ahead?

As we look forward, several economic measures suggest that things could worsen before they improve.

For example, The Conference Board Leading Economic Index (LEI), a composite index commonly used to forecast the strength of the business cycle, clocked in at -6% as of January 30, 2023.

According to Hilton Co-Chief Investment Officer Alex Oxenham, “The [LEI] tends to have a strong hit rate on anticipating recession. The ‘trigger’ is a drop for two or more consecutive (or adjacent) months, followed by a lag of seven to eight months.”

As seen below, drops in the summer of 2022 (June and August) put us on pace for a recession in the second quarter of 2023. And while nothing is certain, this could be a clear signal that a soft landing may be slipping out of reach.

Additionally, the U.S. Treasury yield curve is in its sixth month of inversion, a comparatively rare but concerning development. Inversion occurs when short-term bonds have higher rates than long-term bonds with the same level of risk.

This suggests investors are pessimistic about short-term economic prospects and anticipate future cuts in interest rates will be needed to pull the economy out of recession. Hence, the demand for longer-term bonds一now perceived to have less risk一drives yields below those of shorter-term maturities.

Importantly, inverted yield curves have been reliable bellwethers of recessionary periods, emerging 18 months ahead of a recession on average.

Finally, the December 2022 Institute of Supply Management (ISM) U.S. Manufacturing and Services Purchasing Managers’ Indexes (PMI)一which illustrate forward U.S. demand in these areas一decreased to 48.4% and 49.2%, respectively. Relatedly, the ISM New Orders Index dropped to 45.1%.

While just south of the neutral 50.0% level, the figures are contractionary nonetheless and suggest that declines in demand augur worsening economic conditions ahead.

Our Current Thinking

While it remains unclear whether the Fed will be able to achieve a soft landing, the growing confluence of negative economic data suggests threading the needle between reducing inflation to normalized levels and bringing on a recession could become increasingly difficult.

Regardless, the Fed has signaled that slowing economic growth appears to be a priority, at least for now.

Looking ahead, under certain conditions, we believe 2023 could set up to be a constructive year for a balanced portfolio strategy. After a challenging year for equity and fixed income, correlations could normalize and potentially provide a unique opportunity for capital appreciation.

In particular, a fixed income allocation weighted toward treasury and investment grade corporate securities could benefit from slow growth-driven rate cuts, as described above.

When it comes to high yield and other higher spread products, the Hilton Investment Committee would like confirmation from the economic data that improves the risk/reward relationship associated with these securities before further consideration.

As always, given the uncertainty of the current environment, we will remain cautious as we move forward and continue to reevaluate as conditions unfold.