Playing tighter high yield credit spreads | Insight Investment

High yield may offer more value than you think, even considering the tighter credit spreads today. But those waiting for better entry points should ensure they can execute quickly and efficiently when the time comes.

High yield spreads have tightened, but may offer more value than you think

Although all-in yields on US high yield bonds are in the middle of their range over the last 15 years, credit spreads are near their tightest levels since 2010 (Figure 1).

Figure 1: All-in yields are at their mid-point, but credit spreads are near their tightest levels for 15 years¹

While they may not represent “cheap” value relative to historical levels, a measure of this spread-tightening may be justified by improving fundamentals and default dynamics. We hypothesize three key drivers of this recent price action.

1. Default rates have been muted and recovery rates have risen

Annual US high yield default rates have averaged 2.5% pa since 2008, but since the pandemic they have averaged less than 1% pa. Year-to-date defaults sit at just 0.68%².

Further, when defaults have happened, they have increasingly been “selective” (such as distressed exchanges or liability management exercises), rather than the more “conventional” defaults relating to Chapter 7 or 11 bankruptcies (Figure 2). Selective defaults have had higher recovery rates than conventional defaults, resulting in lower default losses for high yield investors.

Figure 2: Selective defaults now account for a greater share of defaults and their recovery rates have been higher³

The trend toward selective defaults, in our view, reflects an increased desire for issuers to work with creditors to avoid the legal and reputational costs of conventional defaults, as well as increased involvement from private credit, special situation, and “opportunistic” credit vehicles where they see value.

2) Stabilizing credit fundamentals

US high yield fundamentals have been stable over the last year and look healthy across most dimensions relative to history (Figure 3). This positions corporates for a potential downturn and offers comfort that default rates may remain contained.

Figure 3: High yield credit fundamentals have been stable amid economic uncertainty⁴

3) Flows from investors anticipating rate cuts

Since the “Liberation Day” related sell-off in April, US high yield investment flows have been significantly higher than US investment grade inflows as a percentage of overall assets under management⁵. We believe this is partly driven by investors looking to lock in higher yields (which remain historically elevated despite tight spreads) before the Fed kicks off its next round of rate cuts. It may also reflect a desire from some investors for predictable returns in a world of potentially stretched valuations in equity and private debt.

Where next for high yield investors?

The case for at least implementing a leg of high yield exposure

Our recent analysis argues that time in the market beats timing the market. While it intuitively makes sense to wait for spreads to widen, being invested in high yield means earning income, while being uninvested does not.

Consider an investor waiting for a 50bp spread-widening event. Given the high yield market has a spread duration of 2.8 years, such an event would imply a -1.4% sell-off⁶. Current high yield spreads are ~2.8% (or double 1.4%), so the spread-widening event would need to happen within six months to deliver a higher 12-month excess return than a simpler strategy of investing now.

Further, waiting to invest at a higher spread offers no guarantee investing at a higher yield. Since the pandemic, credit spreads have had a negative correlation (of -0.3) with Treasury yields⁷.

For those keen to keep powder dry, make sure you can deploy capital quickly

For those with a strong conviction that a meaningful spread-widening event is imminent, we understand the desire to keep a leg out of the high yield market to hold dry powder. We would, nonetheless, caution against being entirely uninvested.

However, it is important to consider that since the pandemic, risk-market sell-offs have tended to reverse sharply and forcefully, often leaving a brief window for investors to take advantage. During these periods, deploying capital at scale, speed and with a low cost has been challenging. Therefore, we believe investors should consider partnering with a manager capable of generating liquidity in high yield and transacting quickly, cheaply and at scale.

Insight’s systematic fixed income team was a pioneer of “credit portfolio trading” in 2012 by exploiting liquidity within the ETF ecosystem. We find we can reduce high yield transaction costs from 60bp-80bp (for traditional over-the-counter trading) to 10bp-20bp. In our experience, we can transact about $500m of bonds in a day, cutting execution times to hours from days or weeks with traditional approaches.

About Insight’s systematic high yield approach

We believe Insight’s systematic approach offers a robust, liquid, and cost-effective solution for capturing the full benefits of US high yield market exposure. We believe the strategy is innovative and offers the following differentiators:

• Attractive liquidity profile: By accessing ETF liquidity and other tools, our strategy offers fast and broad execution across the full high yield universe, even traditionally thinly-traded, less liquid bonds.
• Model-based alpha generation: We seek alpha through our in-house factor models, allowing for systematic security selection.
• Robust risk management: Insight’s approach offers full diversification across an index and a proprietary quantitative credit model to manage default risks.