High yield is all about risk and reward – and lately risk isn’t being priced appropriately. We remain defensive in our high yield positioning for two reasons, one macro in nature while the other involves dynamics within the market itself. What they have in common is an underpricing of risk and a need to focus on ‘quality.’
From a macro point of view, the tariffs, geopolitical environment and weakening US labour market suggest caution is in order. The other concern has to do with valuations.
High-yield bonds’ current spread-to-worst (a key measure of valuation) is roughly 307 basis points (bps), well below the historical median of about 468. Spread-to-worst measures the yield-to-worst of high yield bonds versus those of US Treasurys of like duration. Higher spread indicates higher compensation for the additional risk inherent in high yield corporate bonds.
Spreads are a bit less tight than they were at the end of February where they stood at 280 bps, near historic lows. Disconcertingly, the only recent time that high yield spreads surpassed the historical median was for a brief ‘blink and you missed it’ moment within the selloff in risk assets after the ‘Liberation Day’ tariff announcement.
The macro environment is giving us pause, even as the market is losing its concern for consequences.
Basically, the macro environment is giving us pause, even as the market is losing its concern for consequences. The US may not be headed toward a recession today, but we think high-yield spreads are telling the markets something. To our way of thinking, they are asking investors to assume conditions are more benign than usual. In essence, the situation both limits the upside and exposes unwary investors to significant risk, should conditions deteriorate.
We don’t expect spreads to widen to peak levels seen in the Global Financial Crisis or Covid era (in excess of 1,000 bps). Yet even if the US avoids a recession, it is likely the tightening cycle will be disrupted, and spreads will widen materially. Accordingly, we are currently positioned with a bias toward higher quality. But we define quality differently from the rating agencies. Whereas we seek a forward-looking view of company financials, agencies tend to rely heavily on quantitative metrics associated with leverage and coverage ratios, which tend to lag market conditions. For example, underlying business fundamentals may improve or deteriorate dramatically with no resulting change in ratings. This approach often misses the big picture, such as industries that have strong current free cash flow but are in secular decline. A perfect example is the wireline telecommunications sector.
In contrast, we emphasise franchise value, industry profile, competitive profile and strength of management and place a premium on a company’s ability to service debt through consistent and predictable free cash-flow generation.
Given our concerns around valuation, high credit underwriting standards across the spectrum of quality continue to define our process.
For more information on Global High Yield Credit.
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