Systematic Insights - 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 (see 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 management³. 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.