This article was produced in partnership with T. Rowe Price
The high-yield credit market is set to find increasing favour with investors as the US Federal Reserve embarks on an anticipated interest rate-cutting cycle, prompting a rotation between that segment and investment grade debt.
While companies issuing what were once known as “junk bonds” – classified as corporate bonds below BBB investment grade – will benefit from easing liquidity conditions, credit spreads are expected to remain tight amid increasing demand for high-yield debt and limited supply, according to advisers and researchers.
“There would be a shift from investment grade to the quality high-yield such as BB and B [rated bonds] in the first stage,” said Ron Mehmet, portfolio manager at Lonsec Investment Solutions.
“As the soft landing develops, and if things improve and rebound from there, investors will go down to the more riskier end of high-yield.”
Institutional investors have been piling into the market since the pandemic as they chased additional returns to compensate for record low interest rates, resulting in yields narrowing compared to investment grade debt.
This reversed somewhat as central banks ramped up rates over the past two years, prompting some investors to exit their riskiest high-yield bonds in favour of better-quality debt, amid concerns about higher bankruptcy filings and weaker economic conditions.
Major economies remained resilient and corporate earnings have stayed positive. Still, persistently high rates have increasingly driven lower grade bond issuers to the private debt market that offers less stringent conditions. While this has improved overall quality in the high-yield market, it has also created a demand-supply imbalance for these investments.
Improving Outlook
A key factor contributing to strong demand has been the improving outlook for defaults as corporate credit risks diminish.
“It’s fair to say that the market had expected a higher level of defaults than has occurred,” says Kevin Toohey, principal at Atchison Consultants.
“Defaults have gone up, but there hasn’t been any big wave.”
S&P Global expects the US speculative-grade corporate default rate to decline to 3.75 per cent by June 2025, down from 4.8 per cent in June this year, which itself is only slightly higher than the long-term average of 3-4 per cent.
The ratings agency cited a number of supportive trends for the forecast, including liquidity relief due to very high levels of refinancing activity, corporate earnings continuing to be resilient, and steady consumer spending. Conditions could improve further if the Federal Reserve cuts rates twice this year, in line with market expectations.
Toohey says the high-yield credit segment is not yet out of the woods, given that there is typically a lag between the economic cycle and when the defaults come through.
“But if we do get this soft landing, it means there hasn’t been a big blow up in the corporate sector even as inflation is somewhat under control,” Toohey says. “That would be really positive.”
Market Churn
Demand for high-yield has already been resurgent this year, with total inflows into US high-yield bond funds between January to May hitting their highest level in three years, according to LSEG Lipper data.
It has led to spreads staying narrower than last year, in the 3-3.5 per cent range, as investors return to the high-yield corporate bond market in the hunt for better returns.
Large investors typically earmark 10-15 per cent of their bond allocation – depending on their risk appetite – into high-yield as a means of enhancing the overall yield of the portfolio.
“Now that the risks are perceived as being less, there’ll be a rotation from investment grade back towards high-yield, with a certain amount of money moving across to create the satellite equivalent in high-yield,” Lonsec’s Mehmet said.
At the same time, easier economic conditions could help some of the issuer companies improve their credit rating, and in some cases even boost them to investment grade, in turn reducing supply in the high-yield market.
“Some of them will get credit upgrades, and at the same time there will be more demand,” he says.
“That should keep the credit spreads tight for high-yield compared to government bonds.”
