Inflation concerns have spelled a worrisome 2021 for many fixed income investors, especially when it comes to the outlook for government bonds. But riskier segments of the asset class have been quietly flourishing.
High-yield debt, which has a strong correlation to equities and a level of exposure to energy and other more cyclical industries, has performed well so far. What’s especially notable is that one part of the market is having its best year in a long time by certain measures. Fitch Ratings noted earlier this month that the default rate for US high-yield bonds came to just 0.4 per cent for the year to date.
To put it in context, this represented the lowest such reading for the start of a year since 2007. Default volumes came to $5.6bn (£4.1bn), a 90 per cent fall from last year’s $55.1bn total. US high-yield debt investors have seen two months with no defaults this year, something not experienced since 2014. Fitch noted that 2021 could “conceivably challenge the six months of zero defaults experienced in 2007”.
Chris Holman, of bond specialist TwentyFour Asset Management, has made similar observations. In a blog post from early August he noted that ratings agencies had upgraded 256 issuers of US high-yield debt, accounting for $354bn, while 111 issuers accounting for $132bn of debt suffered downgrades. This means a ratio of upgrades to downgrades of more than 2:1. In July, US high-yield credit saw 30 upgrades compared with this just nine downgrades.
“When combined with other prevalent market dynamics, the favourable ratings trend paves the way for a highly supportive fundamental terrain as we advance through the cycle and one that is ideal for portfolio managers selecting credits,” he added. “The outlook for the asset class is compelling.”
What’s interesting is such bonds have grown cheaper by some measures in recent months as investors have worried about threats to economic growth. Holman noted that the spread on US high yield, or the difference between the yield it offers versus that of government debt, had widened in July. With yields moving inversely to prices, that means investors are being offered more compensation, and better prices, for taking on riskier debt. Holman noted that a combination of wider spreads and stronger fundamentals could represent an “opportune entry point”.
Investors backing this subsector via the likes of strategic bond and high-yield bond funds do need to remember that it can be closely correlated to equities, and can represent another allocation to riskier assets. But because high yield behaves differently to the likes of government bonds and other more defensive debt, it can give some diversification within a fixed income portfolio.
NN Investment Partners, an asset manager, summed up some of the investment case in a market outlook for the second half of 2021. “High yield offers an asymmetric return profile, outperforming when government bond yields drop and stabilising when they rise,” the firm noted. “Solid corporate strength is another support for the asset class.”
