High-yield bonds: resilient for how long?

US and euro high-yield (HY) corporate bonds have been extremely resilient in the face of this year’s rise in interest rates. Both thanks to lower effective duration and much higher coupons, HY’s total returns have outstripped those of their investment-grade (IG) counterparts year-to-date.

However, cracks have been opening in the riskiest credit segments, such as the lowest-rated HY bonds and leveraged loans. Default rates are rising fast in these areas due to prohibitive financing costs. High financing costs have meant that net issuance in HY has been negative since the start of 2022, as companies postpone refinancing and use cash or other sources of funding instead. One can see the consequence of this in the steep decline in the weighted effective duration of corporate bond indices.

Yields on both ICE BofA US and euro HY indexes remain much higher than for their IG counterparts. As for spreads, they are still the most elevated in the riskiest ratings segments (CCC & lower), especially in euro HY, whereas in the ‘quality’ part of HY (BB-rated bonds), spreads are trading close to their long-term median in euro but well below it in US HY.

This means that HY investors continue to differentiate between bonds that are the most at risk of defaulting and the ones better suited to navigate a higher-for-longer rate environment and an economic slowdown. But while better-quality HY names may look attractive, their already tight spreads mean we prefer to stick to IG bonds. Our continued underweight position in HY is founded on the belief that IG will offer better total return prospects should spreads widen in H2.

For many months, in a context where fast-increasing policy rates have been threatening growth prospects and pushing sovereign bond yields up, our favourite investment theme in fixed income has been short-term (one-to-three years maturity) IG corporate bonds. Now, the attractive absolute levels of US IG yields and the recent surge in US Treasury yields mean we are ready to lengthen the duration of our US IG holdings to at least five years.