Core plus: Time to embrace high yield? | Insight Investment

Given the recent volatility and repricing of fixed income yields and spreads, high yield may be ripe for inclusion within Core Plus strategies.

Can high yield bonds offer higher returns and lower volatility?

US high yield bonds on average currently have around half the duration of US investment grade bonds (Figure 1, left chart).

Therefore, their additional yield can potentially be delivered with lower volatility. At a ~7.8% yield, it would take a ~2.6% rise in Treasury yields to erode the expected forward 12-month return on high yield to 0% (assuming no defaults or credit spread changes). This is a scenario that would send US high yield prices back to levels not seen since the pandemic-related volatility of April 2020.

If we assume unchanged Treasury yields instead, high yield credit spreads would need to widen by over 115bp for their expected excess returns (versus Treasuries) to be 0% in 12 months. For investment grade, it would only take ~15bp (Figure 1, right chart).

Figure 1: At current levels, high yield potentially offers significantly more downside protection than investment grade¹

We believe these characteristics help explain why, despite the market’s reputation, high yield returns are positive year-to-date, even equaling investment grade credit but with lower volatility (Figure 2).

Figure 2: Is high yield doing better than you expected so far this year?¹

We believe the high yield default outlook may be modest

We expect the default outlook to remain relatively benign over the near term, even with tariffs looming. In our view, long-term structural changes have improved the resilience of high yield.

The market’s share of BB debt has trended higher over time (Figure 3, left chart). Further, the “maturity wall” looks more likely a gentle staircase (Figure 3, right chart), which potentially reduces corporate refinancing risks. Additionally, in recent years we have observed riskier debt like distressed issuers and leveraged buyouts increasingly being financed in private credit rather than high yield.

Figure 3: BBs are an increasing share of the high yield market and the “maturity wall” looks benign²

The growth environment may suit high yield

Our current forecast is for US GDP to slow from its 2024 level of 2.5%, to trend in the region of 1% to 1.5% over 2025 and 2026³. Historically, high yield has outperformed investment grade and equities through modest growth environments (Figure 4)⁴. When GDP growth remains modest but positive, equities have tended to struggle to deliver growth. High yield companies, however, have generally been able to service their debt, while paying a higher yield than investment grade bonds.

Figure 4: Slowing growth environments have historically been the sweet spot for high yield performance⁵

Tariff-related uncertainty will make security selection crucial

We expect there to be winners and losers from the evolving US trade policies, so rigorous security selection has the potential to add significant value.

In the current environment, we believe in enhancing a Core Plus strategy by targeting higher quality, less cyclical high yield issuers.

At present, we generally favor high yield bonds with shorter maturity profiles as we believe our credit analysts’ look-through on each corporate’s liquidity profile will offer us a high degree of confidence about the borrower’s ability to prepay by the maturity date.

We generally see value in larger best-in-class names within the high yield market as we see them as having the greatest potential for resilience in the face of ongoing political uncertainty.

Due to the introduction of tariffs, our favored names for Core Plus strategies are domestically focused businesses like Carnival Corporation or Venture Capital LNG and household names like Sirius XM and Iron Mountain⁶.

We also believe investors can add value if high yield credit default swaps are part of their toolkit⁷. Given their relative liquidity, we have found that they can be used to play offense, not just defense, helping us strike quickly when value opportunities present themselves.

Conclusion: time to consider opportunities across the full fixed income universe?

While the Bloomberg US Aggregate Bond Index currently offers a ~4.6% yield, we believe that a carefully designed Core Plus strategy can potentially yield above 5% and closer to 6% by taking a flexible approach versus the benchmark.

We believe that a Core Plus strategy that focuses its exposure on corporate bonds and mortgage-backed securities (rather than Treasuries) and seeks to enhance its yield profile through off-benchmark investments like selective high yield bonds, can add meaningful value than a benchmark-constrained vehicle.