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High Yield: The Valuations Conundrum

High Yield: The Valuations Conundrum
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ARTICLE TYPE
Insights
TOPIC
Credit,High Yield
PUBLISHED
July 10,2023
READ TIME
6 mins
AUTHOR
Kevin Bakker, CFA
Ben Miller, CFA
Thomas Hanson, CFA
Mark Benbow
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Back
ARTICLE TYPE Insights
TOPIC Credit,High Yield
PUBLISHED July 10,2023
READ TIME 6 mins read
AUTHOR Kevin Bakker, CFA
AUTHOR Ben Miller, CFA
AUTHOR Thomas Hanson, CFA
AUTHOR Mark Benbow
SHARE

  • High yield investors are facing a conundrum as they evaluate valuations and entry points.

  • Yields around 8% look attractive, however spreads could be biased toward widening in the short term.

  • Although timing the market can be challenging, current yields can provide compelling long-term total returns and dislocations may present opportunities to add high yield exposure.

 

Attractive yields and total return potential

As rates have shifted higher, high yield is now living up to its name. Since 2008, there have been relatively few opportunities to invest in high yield at yields above 8%. Many investors who allocated to the asset class during these times, benefited from double-digit total returns over the subsequent one-, three- and five-year periods. Since 2008, the average annualized forward return for the Bloomberg US Corporate High Yield index ranged from approximately 11% to over 18% when the starting yield to worst was higher than 8%. The results are similar for the global high yield market.

Exhibit 1: Yields above 8% are relatively rare, and can present above-average total return potential
Yield to worst for the Bloomberg US Corporate High Yield Index

7-10-23-HYConundrum-Ex1.jpg

Past results are not a reliable indicator of future performance. Source: Aegon AM and Bloomberg. Based on monthly Bloomberg US Corporate High Yield Index data from January 1, 2008 to May 31, 2023. One-, three- and five-year returns are based on the forward annualized index return for months where the starting yield to worst was above 8%. Three-and five-year returns based on 44 months and 43 months, respectively, that had starting yields of more than 8%. Data is provided for illustrative purposes only. Indices do not reflect the performance of an actual investment. It is not possible to invest directly in an index, which also does not take into account trading commissions and costs. All investments contain risk and may lose value.

 

Assessing spreads and future return potential

While all-in yields are attractive, spreads remain around historical averages, leaving many investors grappling with the right time to increase their high yield allocation. Given the macro uncertainty, it is unlikely that we will see sustained spread tightening in the near term, although relatively tight market technicals can exert positive pressure.

 

Although spreads could be biased toward widening in the short term, we expect this could be more contained than during previous downturns given the higher-quality composition of the high yield market today relative to prior downturns. Previous recessions have resulted in spreads widening above the 800 to 1,000 basis-point (bps) level. However, many of these periods were also during times of much lower risk-free rates. For example, the spread widening witnessed during 2020 occurred when rates were at historically low levels.

 

As a recession becomes more imminent, it is feasible that spread widening is more contained to around 600 to 700 bps given the higher-quality composition of the market and the solid fundamental starting point. Additionally, periods of spread widening could be short-lived, depending on the macro backdrop. We believe that the majority of the Federal Reserve’s rate hikes have already occurred and that when the economy turns, rates are likely to decline, which could help offset some of the spread widening. Additionally, after massive outflows from the high yield asset class in 2022, we may well witness a wave of inflows as opportunities arise and investors shift toward overweight, which could in turn provide supportive technicals and potentially result in swift spread tightening.

 

While it can be challenging to time the bottom or top of the market, we believe current yields can provide appealing long-term total return potential. In addition, we expect dislocations to emerge, presenting opportunities to capitalize on bouts of spread widening. As shown below, the high yield index has historically generated average returns over 7% during the subsequent three- and five-year periods based on a starting OAS of 400 to 800 bps. The results are similar for US and global high yield indices. 

 

Exhibit 2: 3-year forward high yield index returns based on starting OAS 
Bloomberg US Corporate High Yield Index (monthly data from January 1994 through May 2023)

7-10-23-HYConundrum-Ex2.jpg

 

3-Year forward annualized
index % returns

Starting OAS

400 bps

500 bps

600 bps

700 bps

800 bps

Minimum

(3.45)

(2.44)

0.83

4.71

5.91

Median

8.27

9.54

11.51

12.79

15.94

Average

8.61

9.76

11.74

13.79

16.49

# of months of positive returns

172

124

85

50

24

# of months of negative returns

9

3

0

0

0

 

Exhibit 3: 5-year forward high yield index returns based on starting OAS  
Bloomberg US Corporate High Yield Index (monthly data from January 1994 through May 2023)

7-10-23-HYConundrum-Ex3.jpg

 

5-Year forward annualized
index % returns

Starting OAS

400 bps

500 bps

600 bps

700 bps

800 bps

Minimum

(1.82)

4.00

5.32

7.48

8.34

Median

7.89

8.31

9.35

10.90

12.65

Average

7.34

9.02

10.21

11.62

13.63

# of months of positive returns

170

122

82

48

23

# of months of negative returns

3

0

0

0

0

 

Past results are not a reliable indicator of future performance. Source: Aegon AM and Bloomberg. Based on monthly Bloomberg US Corporate High Yield Index data from January 31, 1994 – May 31, 2023. The 3- and 5-year returns are based on the forward annualized index return for months where the starting OAS was at or above the level shown. Data is provided for illustrative purposes only. Indices do not reflect the performance of an actual investment. It is not possible to invest directly in an index, which also does not take into account trading commissions and costs. All investments contain risk and may lose value.

 

Time in the market, not timing the market

Overall, we believe yields around 8% can present attractive opportunities for long-term investors. Depending on your appetite for volatility, this may not be the environment to stretch for unnecessary risk in lower-quality CCC bonds, particularly when there are interesting opportunities to generate solid returns in higher-quality high yield bonds. 

 

In this environment, we think there is a case to be made for long-term investors to consider gradual increases to high yield in an effort to capitalize on attractive yields, provided they can weather some short-term market swings. Spread widening may present opportunities to further increase allocations, however timing the bottom or top of the market can be challenging. After all, it is time in the market, not timing the market, that matters in high yield.

 

Over the long term, high yield has tended to deliver competitive risk-adjusted returns compared to many other fixed income assets, and even equities. As such, we believe the structural case for high yield remains very much intact. And throughout the remainder of the year, we expect high yield has the potential to generate attractive carry and solid coupon-like returns.

Important disclosures

AegonAM_High_Yield_The_Valuations_Conundrum.pdf

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More about the authors

Kevin Bakker, CFA Co-head of US High Yield & Senior Portfolio Manager

Kevin Bakker, CFA, is co-head of US high yield and a senior portfolio manager responsible for US and global high yield portfolio management

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Ben Miller, CFA Co-Head of US High Yield & Senior Portfolio Manager

Ben Miller, CFA, is co-head of US high yield and a senior portfolio manager responsible for US and global high yield portfolio management.

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Thomas Hanson, CFA Head of Europe High Yield

Thomas Hanson, head of European high yield, is a member of the global leveraged finance team.

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Mark Benbow Portfolio Manager

Mark Benbow, portfolio manager, is a member of the global leveraged finance team. He specialises in high yield bonds and co-manages our global high yield strategies.

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