With attractive valuations, low expected defaults and Fed support, the upper-tier high yield bond market might provide some investment opportunities.

In Brief

  • We believe investors can find compelling value in the upper tier of high yield bonds, excluding energy.
  • While average BB credit yields at around 6% may seem low, they are attractive relative to risk-free interest rates—in the context of the low-rate regime that we expect to endure for some time.
  • With BB rated yields trading at more than 500 basis points above risk-free rates, we believe investors are receiving compensation for potentially high levels of defaults—in a cohort of bonds that doesn’t usually experience a high rate of defaults.
  • The Federal Reserve (Fed) has begun to offer support for the high yield space, for the first time becoming a buyer with its emergency purchasing programs, creating a new source of demand.

The high yield (HY) credit market, including its upper-tier BB grade,1 was never eligible for central bank bond purchases. In recent weeks, that changed—but that’s only one rationale for the case we see for the upper-tier high yield bonds, excluding energy.2

Even more important than the Fed’s announcement of support for the space, in our view, is a low probability of credit defaults and ample compensation for the risk of default.

We exclude energy from our upper-tier HY thesis, in recognition of the extraordinary supply and demand challenges at play. Excluding the underperforming energy sector should also significantly reduce volatility.

Let’s take our rationales one by one:

The Fed’s announcement sparked a HY rally, narrowing spreads (the premium over Treasuries investors require) that had widened amid the pandemic. Spreads are still high, however: On the J.P. Morgan Domestic High Yield BB Index, they are currently around 6%—a rarity. Since 1995, the index has spent less than 10% of the time offering this much (or more) spread. Statistically, credit spreads tend to revert to the mean, which is narrower, so we should expect them to compress from here. How can we expect HY bonds to perform, given spreads at current levels? Historically, current spreads imply a total expected return over Treasuries of about 9.8% for the next 12 months—despite current yields around just 6%.

Six percent may seem low for high yield, but not relative to the current risk-free rate. We are in a low-rate environment that we expect to endure. We see the fed funds rate lingering near zero for at least a few years and 10-year Treasury rates approaching merely 1% at year-end.

HY investors looking for more yield may deploy leverage. Based on historical experience, current BB rated spreads with one turn of leverage3 imply an expected return of 21.8% over the next 12 months, potentially with roughly half the volatility of the S&P 500.

History suggests BB spreads, with leverage, could return 21.8% over 12 months—with half the S&P 500’s volatility

Source: Bloomberg Finance L.P., data between 1995 and 2019; data as of December 31, 2019. 1x leverage is USD1 of equity for every USD1 of leverage.
The chart show that historically total returns increase as credit spreads increase. With spreads where they are now history suggests BB rated credits may experience 9.8% total returns over the next year.

With BB rated spreads trading at more than 500 basis points (bps) above risk-free rates, we believe investors are receiving compensation for high default levels—in a cohort of bonds that doesn’t usually experience a high rate of defaults. Put another way, the market appears to be overestimating likely BB default rates for the better credits.

BB rated defaults have not exceeded 4% since 1982 and have trended lower with each successive business cycle peak.4 During the global financial crisis, the percentage of BB rated credits that defaulted stayed below 1% annually. Current BB rated spreads imply a default rate of 3.4% over the coming year: That’s roughly double the average default rate during recessions since 1995.

Default compensation looks ample

Sources: S&P Global Ratings, J.P. Morgan; data as of April 13, 2020.
The chart shows that credit spreads are historically much wider than realized defaults. Currently spreads around 6% are compensating investors for defaults that we have never experienced.

The Fed’s new emergency programs now offer liquidity and financing to the top tier of HY bonds. The Fed has become a lender of last resort to the HY market—a luxury this market has never had—which creates confidence, even if the actual flow of financing will likely be quite small. Under the Fed’s criteria roughly USD400 billion of investment grade and HY bonds appear to be eligible for purchase.5 Since the Fed has only deployed about half the allocated funds, this footprint could increase considerably, if conditions warrant.

The Fed is concentrating its HY purchases in certain “fallen angels”—investment grade bonds that were downgraded after March 22. This eligible universe is currently about USD75 billion of bonds and growing. Even if the Fed only purchases a relatively small volume of fallen angels, its buying helps mitigate investor concerns about a wave of downgrades flooding the high yield market with no obvious buyer.

We expect investors can find compelling value in the top-quality tier of high yield corporate debt, excluding energy, where appropriate for their portfolios. The introduction of the Fed as HY lender of last resort is likely to breed confidence in the market’s liquidity. And while yields around 6% may seem low, we believe they are, and will remain, attractive versus risk-free interest rates, as a low-rate regime is likely to endure for a long time.

1 BB refers to a credit rating; BB corporate bonds, considered a speculative investment, are also sometimes nicknamed “junk bonds.”

2 BB bonds represented by the J.P. Morgan Domestic High Yield Index (JPDOBB Index).

3 USD1 of leverage for every USD1 of equity.

4 Moody’s historical annual default data; 1982 is the earliest point from which data is available.

5 The largest Fed flows will likely be going into investment grade bonds. Eligible HY credits are concentrated in the BB space due to leverage restrictions; fallen angels—investment grade credits downgraded to HY—in cases where downgrades occurred after March 22; and up to 20% of high yield ETF shares.