The high-yield bond market has enjoyed a good couple of years. The ICE BofA Global High Yield index returned 7% in 2023 and 9.4% in 2024 in sterling terms, having lost 2.3% in 2022.
Yet going forward managers are grappling with the challenge of tight spreads and unappealing valuations, balanced against attractive all-in yields and buoyant demand for high-yield bonds, complemented by strong corporate fundamentals.
Whether or not this makes high-yield bonds a good place to invest depends on who you talk to. Strategic bond managers at Rathbones and BlackRock are reducing their high-yield exposure whilst JPMorgan Asset Management is doing the opposite.
Below, fund managers explain their positions and articulate the bull and bear cases for high-yield bonds.
The high-yield bears
Ben Edwards, co-manager of the BlackRock Sustainable Sterling Strategic Bond fund, has been gradually reducing high-yield exposure throughout 2023 and 2024 because tight spreads are not providing sufficient compensation for credit risk – and in the European high-yield market in particular, he is concerned about the economic growth outlook. As a result, his fund currently has a net short position of -10% in high yield compared to as much as 65% long two years ago.
In the same vein, Bryn Jones, head of fixed income at Rathbones, has been reducing the Rathbone Strategic Bond fund’s high-yield exposure and taking a more defensive stance during the past eight months. “We’ve allowed some of our legacy bank debt that's been tendered and some of our secure cash flows to unwind and we’ve been putting that into more defensive duration assets,” he explained.
Jones is concerned about the impact on corporate profitability if companies need to refinance at higher rates. “If we're in an environment where rates are remaining higher for longer, it means refinance risk [in 2025] becomes huge,” he said.
“Over half of the European high-yield market needs to refinance in 2025 and 2026. If they have to do that by a rate that eats into their margins […] it means that the market becomes less stable if we have a shock.”
Therefore Jones forecasts that, in 2025, fallen angels (companies getting downgraded from investment grade to high yield) will outnumber rising stars (high yield issuers getting upgraded). In previous periods when this happened, such as 2020, 2016, 2011 and 2008, high yield spreads widened aggressively, he said.
The high-yield bulls
On the other hand, high-yield bonds were the best performing component of the JPM Global Bond Opportunities fund last year. Within high yield, CCC-rated bonds outperformed BBs as fears of a hard landing receded, said Iain Stealey, international chief investment officer for global fixed income at JPMorgan Asset Management.
At the start of 2023, JPMorgan Asset Management was predicting a recession but by summer the economy was holding up better than expected and the ‘long variable lag’ of interest rates impacting the broader economy was proving to be much longer this time compared to previous cycles. This economic resilience gave Stealey confidence to begin increasing his allocation to investment-grade credit and high-yield markets in the summer of 2023.
The JPM Global Bond Opportunities fund, which is a flexible, best ideas fund, had 39% in high yield and 61% in investment grade as of 31 October 2024.
One reason to own high yield is that default rates have continued to come down as the US economy has avoided a recession, he said, adding that all-in yields of 7.25% remain attractive despite tighter spreads.
Looking forward, Stealey disagreed with Jones about the imminent refinancing risk.
There was a lot of issuance in 2024 after companies held off from refinancing in 2023 when yields were even higher, at around 9-10%, he said. So although the maturity wall was a concern at the start of 2024, it has effectively been pushed out.
“In my 22 years of working here there have been numerous maturity walls to be concerned about and they always just seem to fall over or get knocked down or the market just climbs over them,” he said.
Mike Benbow, portfolio manager of the Aegon High Yield Bond fund, said there were also positives from the demand side, with more buyers than bonds available. “People are yield hungry”, he said.
Another reason why demand is outweighing supply is because the high-yield market has shrunk by 10-15% since the start of 2022, partly because some companies are issuing debt in the private markets and also because of net upgrades to investment grade, he explained.
High rates are “horrid” for issuers but attractive for investors, he observed. For instance, Asda issued bonds yielding 8.125% in May 2024 whereas when rates were low, back in February 2021, its bonds were yielding just 3.25%.
However, even with these elevated yields, the average high-yield issuer can pay its coupons 4.5 times over and so although interest coverage has fallen as coupons have risen, he is not concerned about default risk. The consensus outlook amongst investment banks is for default rate is as low as 1.5%, whereas the long-term default rate is 4%.
Despite the strong technical backdrop, the biggest argument against investing in high-yield bonds at present is valuations. “I can’t even pretend they are close to fair value. Spreads are super, super tight,” Benbow acknowledged.
However, he believes yields are a more important driver of returns than spreads and said that starting yields are a good predictor of total returns. The Aegon High Yield Bond fund is yielding 8% and the high-yield market in general is yielding in the low sevens.
The yield curve is currently inverted, meaning that investors are being paid more for owning shorter duration debt, which is less risky and less volatile. This phenomenon has allowed Benbow to de-risk his portfolio by buying bonds closer to their maturity dates – “a win-win”, he said. Reducing duration “protects you and pays you”.