After the high yield market posted double-digit returns in 2023, some investors are wondering if the strong performance can continue as recession risk looms on the horizon. While this environment warrants caution, investors should take a closer look at one key metric to avoid missing out on attractive opportunities in the bond market, according to Thomas Hanson, head of Europe High Yield at Aegon Asset Management.
Hanson believes there is little doubt that the bond market has come back to life after years in the doldrums, but he says investors are still caught in a quandary between attractive yields and tight spreads.
“After years of low rates, bonds are back. From government bonds to investment grade and high yield corporate bonds, rising rates have ensured there’s no shortage of yield in the market today. This leaves many investors debating fixed income allocations as they evaluate risk positioning and total return potential across the quality spectrum.
“When it comes to high yield bonds, many investors have grappled with the optimal time to add exposure. Yields around 7.75% look attractive; however, spreads inside long-term averages and potential looming recession risk in certain parts of the global market have given many investors pause for thought.
“While some macro headwinds persist, and it is right to be cautious, long-term investors mustn’t lose sight of the bigger picture. Yes, it is likely that spreads are biased towards widening in the medium term, as there is little room for substantial tightening after the rally in 2023. However, we believe current yields in the global high yield market present a relatively rare opportunity for long-term investors to generate above-average total returns.”
Hanson says investors can take comfort from both the elevated starting yield relative to history, as well as a substantial breakeven (yield divided by duration) that offers some protection against spread widening. In particular he highlights ‘yield-to-worst’, an estimate of the yield an investor can receive on a bond if held to maturity or call date, and assuming no issuer default.
“The attractiveness of an asset class can be evaluated using various metrics including yields, spreads, expected returns, etc. While each of these metrics may provide a different signal, the starting yield-to-worst tends to be a reasonable estimate of the forward five-year annualised returns based on index data. This relationship has generally held true across various time periods.
“In both strong and weak economic environments, as well as periods with tight and wide high yield spread levels, the starting yield-to-worst has been close to the subsequent annualised five-year return for the global high yield index.
“With a starting yield around 8% on the global high yield index, we think high yield bonds look attractive for long-term investors, provided they can withstand some short-term volatility.”[1]
ICE BofA Global High Yield Index monthly YTW and forward five-year returns
Past performance does not predict future returns. Outcomes, including the payment of income, are not guaranteed.
Source: Aegon AM and Bloomberg. Based on monthly ICE BofA Global High Yield (HW00) index data and includes the index YTW and forward five-year annualized return in local currency for certain time periods.
While highlighting the tendency for this trend to play out over five-year periods, Hanson stresses that it is essential for investors to stay the course over the long term.
“As we all know, markets do not move in a straight line,” he says. “Many yield-to-worst timeframes are accompanied by short-term volatility within a five-year period. However, high yield bonds benefit from higher coupons and enhanced income, which can help cushion against adverse spread movements.
“In this environment, we believe long-term investors should remain focused on the bigger picture as they balance caution and optimism. Over the long term, the structural case for high yield remains intact with the potential for equity-like returns and lower volatility.”
For investors that want to be more tactical, Hanson expects modest spread widening will present opportunities to add high yield exposure in the year ahead. He notes, however, that wider spread environments have historically been short-lived, requiring investors to act quickly.
“For this reason, the old adage that it’s ‘time in the market, not timing the market, that matters most’ holds true in high yield. Markets may be volatile in the short term, but we think high yield looks attractive for investors with a longer time horizon.”
