High yield in sweet spot amid government bond turbulence

With Covid-19 vaccination programmes well underway in many countries, the summer of 2021 looks set to herald a broad reopening of society. This, in turn, looks likely to precipitate one of the most pronounced, synchronised, economic expansions since records began.

The improved economic outlook brings challenges for investors in fixed income. With deposit rates anchored at extremely low (or even negative) levels, income-producing assets remain in high demand. On the other hand, as markets look to “price-in” the dramatic change in growth outlook, uncertainties about forward monetary and fiscal policy abound. This has resulted in volatility in global government yields and negative total returns year-to-date in many parts of fixed income.

New challenges for bond investors

In this context, investors are rightly asking themselves whether they are being correctly compensated for this increased volatility. Historically, in moments of cyclical expansion, fixed income investors could look to the absolute or relative gains resulting from spread compression in corporate bonds. This is when bond yields in one part of the market converge toward those of a less risky part of the market. This has often helped investors to offset losses from rising long term rates.

So far in 2021, however, investment grade total returns have been negative (bond prices fall when yields rise). Spread compression has resulted in excess returns over government bonds, but it has been unable to fully compensate for the sell-off in government bond markets.

High yield cushioned against turbulence in government yields

High yield – the sub-investment grade end of the credit rating spectrum - has been a clear winner in this environment. It  has been helped both by spread compression and the comparatively short duration of the asset class (a measure of bond price sensitivity to changes in yields or rates).

Below we compare the duration, yield and resultant breakeven interest rate moves of European high yield and investment grade markets. Breakeven rate is calculated as yield divided by duration, and illustrates how much yields would need to move higher before an investor would suffer negative total returns.

As we can see, high yield has both the carry and the spread compression potential to “cushion” shocks to interest rates, as well as carrying a low overall duration. The breakeven rates are even more attractive if compared to negative European deposit rates.

Looking at correlation of past returns with those of 10-year Bunds we can see that positive correlations, when both Bunds and high yield bonds sell off, tend to be short-lived and usually present an opportunity to buy high yield.

We believe that this will continue to be the case over the course of 2021, particularly since higher rates are broadly a reflection of an improved economic outlook, which should allow high yield companies to deliver higher profitability and improvements in creditworthiness.

A hawkish shift in monetary policy, which would be a more concerning reason for rising rates, we believe remains some way off.

Other supportive factors for high yield are the benign outlook for ratings downgrades and defaults.

The chart below shows the distressed ratio, which is the percentage of the high yield market with a spread of 1000 basis points or more over equivalent government bonds. This has historically been a reliable leading indicator for future default rates. It currently points to a falling default rate over the coming months. On the ratings side, a historically low proportion of the high yield market is on review for downgrade, suggesting that the downgrade cycle is also past its peak.

While the backdrop for high yield looks broadly supportive, a selective approach is important amid continued uncertainty around the pandemic and parts of the market at elevated levels. The attractive income, relative to almost all other areas, and modest duration puts high yield in a sweet spot for the rest of this year.