According to experts, it takes a lot to bring down the global high-yield market. The high effective yields help absorb rising credit losses in a recession.
The escalating trade war has not left high yield untouched. In the US, risk premiums rose by a total of 93 basis points last week. Investors fear a deep recession. But things may not turn out as bad as they seem, said Jonathan Butler, head of Global High Yield at PGIM Fixed Income.
“Donald Trump put on quite a show for television, and naturally, markets were shocked. Countries are responding with countermeasures, and in the end, this is the starting point for negotiations. Trump has changed his mind several times before, and it could happen again.” Butler advises investors to keep a cool head. “The trade war won’t cause a deep recession but will likely just slow growth in the short term, since Trump has indicated he’s looking for trade deals.”
Comparable to Covid-19
The high-yield market entered this turbulent period with relatively low risk spreads, comparable to the record-low levels seen just before the 2008 credit crisis. However, spreads have widened by about 200 basis points since their February low. Adjusted for risk, they are even higher, says Butler. The quality of high-yield indices is better than it was before the credit crisis, with more BB ratings and fewer CCC ratings. “If we do enter a recession, one would expect the peak in default rates—and thus in spreads—to be lower than usual. Spreads may rise further, but not to the extent we saw during the 2008 credit crisis. It’s more likely to resemble the heightened volatility we saw during the Covid-19 crisis.”
Butler also notes that the US market is now less sensitive to interest rates than before. “Quality has improved, while duration has decreased. This has made the US high-yield index more defensive and reduces downside risk.”
Worst may be over
In PGIM’s base case, defaults remain low. “If the economy does slip into a recession, the current effective yield of over 8 percent provides a solid buffer against rising credit losses,” says Butler. “We were already underweight in sectors sensitive to higher import tariffs, such as the auto industry, and it now seems the worst may be behind us. The moment to reduce our defensive positioning could be approaching soon.”
PGIM also invests in private debt on behalf of clients, but Butler expects this category to perform similarly to high yield during a recession. “Private debt issuers benefit from variable coupon rates, which means they immediately gain from potential rate cuts. On the other hand, private credit is more exposed to smaller companies, which often offer just one product or service, making them more vulnerable in a recession. Additionally, credit ratings in the US average a low B-/B3.”
Uitzicht op een totaalrendement van 7 tot 9 procent. Bij een diepe recessie is dat eerder 1 tot 3 procent.
Tom Ross, Janus Henderson.
According to Janus Henderson, the threat of a deep recession has diminished after Trump’s shift in stance. Still, a mild recession is possible, said Tom Ross, head of High Yield at the UK-based asset manager. He points to the uncertain outcome of upcoming negotiations with the US over the next ninety days. Some tariffs on China remain in place, as do the 20 percent duties on aluminum and automobiles. “Even so, we expect default rates to rise only slightly in a mild recession,” said Ross. “In that scenario, high yield would still deliver a positive return. The higher starting yields now offer a solid cushion against rising defaults. It would really take a significant recession to push total returns into negative territory in the coming years.”
Lower leverage
Ross is not worried about a repeat of the disastrous year in 2008, when the global high-yield market suffered an unprecedented 27 percent drop. “The credit crisis back then triggered a deep recession, and market participants were forced to unwind positions due to excessive leverage. Leverage in the system is much lower today.”
According to Ross, current effective yields provide the best indication of expected returns. “In US dollars, yields currently stand at 8.5 percent, while in euros they’re a few percentage points lower. That’s quite attractive and offers a total return outlook of 7 to 9 percent for this year,” said Ross. “If a deep recession does occur, returns would more likely fall in the 1 to 3 percent range. Despite all the uncertainty, this is a good moment to lock in high yields and invest in high yield, investment-grade corporate bonds, or other spread products.”
Early redemptions
In the US, spreads already offer plenty of value for investors, according to Ross. “In recent weeks, we’ve increased our position in the US high-yield market based on attractive valuations compared to Europe. In the past ten years, BB spreads in Europe were only wider during the Covid-19 outbreak and the energy crisis. A lot of bad news is already priced in.”
Moreover, the relatively tight spreads—especially in the US—are more attractive than they appear, he said. “Spreads may seem narrow, but bond prices are significantly lower than expected. Companies financed themselves in recent years at very low coupons and are therefore postponing refinancing. But the pressure on these firms to refinance well before their existing debt matures is mounting.”
Roughly 80 to 90 percent of the global high-yield universe is callable early. “Holders of high-yield bonds trading below par can therefore expect an additional return. Taking this into account, spreads are actually 30 to 40 basis points higher than current market levels suggest.”