High Yield: Differentiation returns to drive the next leg of performance

With an impressive 12.29% return¹, high yield bonds were the best-performing sub-sector of the fixed income universe in 2023. To investors’ delight, that relative momentum has been maintained into 2024, despite spreads being tight, and there are signals of further good news ahead.

The high yield market has behaved similarly to global equities if you strip out the outlier performance of the ‘Magnificent Seven’, benefiting from the shift towards risk-on, fuelled by signs of falling inflation and the prospect of rate cuts – even if they are delayed and fewer in number than originally expected.

But what we think is really interesting about high yield as we move into spring is the increase in differentiation between the US and Europe.

US high yield is essentially flat on the year². Within that, B and CCC rated bonds rallied strongly over Q1 but have since sold-off, along with the rest of US high yield as the effects of interest rate uncertainty have impacted US credit generally.

In contrast, dynamics in European high yield have become very interesting. Over 12 months, Europe has outperformed the US by 1.8%³, which in itself is a pretty rare occurrence. But what’s even more interesting is that the European market has outperformed despitethe fact that it has more BB bonds in its universe. Indeed, BBs have led the European market year-to-date, up 1.86%⁴. BB rated bonds have generally outperformed their US counterparts and have not sold off to the same extent in Q2 of this year.

The driver of this differential comes from the different expectations around interest rate paths for Europe versus the US. A first cut in the summer remains likely for Europe, while later this summer or even further out is looking more plausible for the US.

As an active manager, it’s good to see the return of differentiation between rating categories that are classically more interest-rate sensitive like BBs, and those more influenced by factors like idiosyncratic risk, which is the case for CCCs. This creates potential value-add opportunities across geographic allocations and credit selection.

On a global view, the high yield market was yielding 8.11% at the end of April⁵. While this is a touch off the 9-10% that we view as an automatic “buy” signal, strong coupon generation is keeping performance motoring and is only likely to increase as rates remain “higher for longer”.

Despite the market largely pricing out early interest-rate cuts, performance has been maintained by a healthy underlying economic environment for credit. Tailwinds include limited supply, thanks to lots of names refinancing early, as well as multiple “rising stars” moving back up to investment grade. Additionally, you’ve got investors looking to deploy cash, both from coupon income and new allocations.

It would be remiss of me not to mention that we’ve seen a couple of headline-grabbing negative credit events recently, but these have resulted from idiosyncratic stories around very large-cap structures struggling against poor results and refinancing issues. Overall, the Q1 results season left corporates on firm footing with the asset class supported by healthy tailwinds, which in my view, should set it up for continued positive performance. When we see firm signs of rate cuts coming through, that should provide an extra boost to risk-appetite.

In our portfolios, we’ve been adding coupon risk as we see that as the best way of generating returns within high yield as we tread water ahead of rate cuts. The US offers greater coupon return potential and has the stronger underlying economy, but that must be weighted up against the return of differentiation in Europe, which we would expect to outperform given the more benign growth and inflation environment.

We think a quality stance in Europe with a little bit more interest-rate sensitivity is probably a good thing versus the US, because you've got at least one rate cut coming from the European Central Bank in the next couple of months, as reflected in the outperformance of BBs. Investment flexibility around regional allocations allows us to make top-down decisions based on where we see macro drivers and pressures, while we’re giving significant weight to bottom-up research in the current environment to avoid idiosyncratic risks.