Healthy fundamentals, a higher-quality market and attractive all-in yields continue to support high yield, even as tight spreads raise the bar for security selection.
The high-yield market appears expensive at first glance. Spreads sit near the tight end of their historical range, which implies limited compensation for credit risk. However, spreads relative to their historical levels do not capture the full opportunity set of the asset class. Corporate fundamentals remain healthy, defaults are low, and the quality of today’s high-yield universe is higher than its long-standing reputation might suggest.
The result is that high yield investing is more complicated than a simple risk-on or risk-off call. High yield still offers a constructive income opportunity, but tight spreads leave less room for mistakes. In this environment, the case for the asset class rests less on expectations of further spread compression and more on income generation and disciplined credit selection. In this market, avoiding the losers may be just as important as finding the winners.
Look Beyond Spreads
When viewed through a broader lens, high yield may be more attractive for diversified portfolios than spread levels imply. Indeed, spreads are just one way to estimate a high-yield investor’s potential return. All-in yields matter, too, particularly for investors seeking income. Credit quality, cash generation, and the likelihood of default are important factors to consider as well.
The backdrop for credit fundamentals remains supportive. Moderate economic growth and solid corporate earnings should continue to help borrowers meet their obligations. While the possibility of a material increase in defaults cannot be dismissed, such an event would require a significant deterioration in fundamentals or an unpredictable external shock. This is not the base case implied by current conditions.
See more: Keeping Your Float Afloat: A Guide to Earning What You Deserve on Your Cash
A Higher-Quality High-Yield Market
The composition of the market is another important consideration for investors. Today’s high-yield universe holds a larger proportion of higher-quality issuers than many investors appreciate, given their experience of historical cycles. Many companies have managed their balance sheets conservatively and addressed upcoming maturities, reducing the near-term refinancing pressure that can turn market volatility into credit distress.
That does not eliminate risk. High-yield companies remain more vulnerable than investment-grade borrowers to weaker growth, higher financing costs and company-specific setbacks. But a healthier starting point can provide a meaningful margin of safety, especially when a benign forward-looking default environment allows investors to earn income without relying on a broad rally in risk assets.
For this reason, today’s market opportunities should not be judged against an outdated image of the high-yield asset class as a uniformly speculative market. Even if the overall market appears richly valued, those valuations reflect sturdy fundamentals, and active managers can still identify opportunities that offer attractive income relative to their underlying risks, particularly for investors willing to be selective rather than simply buying the index.
The Case Against Market Timing
None of this means that the high-yield market will move linearly. The market can be volatile, and exogenous shifts in interest rates, energy prices, economic expectations or investor sentiment can quickly affect valuations. The challenge is that these moves are extraordinarily difficult to anticipate.
Large directional calls on rates, market beta, or oil prices may introduce material risk of underperformance. In our view, a more durable approach is to focus on the characteristics of individual borrowers such as their cash flow sustainability, capital stack structure, management’s willingness for candid communication, and the amount of leverage the business can reasonably take on.
Avoiding companies with excessive leverage, poor transparency or structural challenges can be just as important as identifying the strongest credits. When broad valuations offer less room for error, discipline at the issuer level becomes the first line of defense.
New Risks Reinforce the Need for Selectivity
Artificial intelligence (AI) offers a timely example of why bottom-up portfolio management matters. AI has largely been discussed within an equity-market context, but technological disruption can also lead to credit issues when it weakens a company’s competitive position, erodes recurring revenue or requires heavy capital expenditure simply to keep pace.
The pressure from advances in AI technology has been most evident among software borrowers in the leveraged-loan market, but the lesson applies to high-yield broadly. Some businesses have entrenched customer relationships, mission-critical products, or proprietary data that may be difficult to replicate by an AI-powered competitor. Other companies may leverage AI to strengthen their current product offerings. Still others may discover that their business models are simply less durable than investors expected.
So, is a lower bond price an opportunity or a warning? Distinguishing between the two possibilities requires understanding a company’s products, how easily their customers can switch providers, the extent to which a new technology is a substitute or an enhancement, and whether management is candid about these risks. Traditional credit analysis needs to incorporate a clear view of industry disruption.
Income With Discipline
The broad backdrop for high-yield remains constructive. Economic growth is moderate, earnings are solid, the market is higher quality than in past cycles and, in our view, defaults are likely to remain contained, absent a significant macroeconomic shock. These conditions argue against dismissing the asset class outright on the basis of tight spreads.
At the same time, relatively rich valuations make selectivity essential. The next phase of the market may be defined less by a broad collapse in fundamentals than by widening dispersion among individual companies and industries. Investors should not expect market beta alone to do the work.
For investors seeking income, high-yield investing can still play a valuable role. But the opportunity is best approached with realistic expectations. Investors should resist the temptation to time every market move, and focus on generating income via debt issued by companies with the cash flow, transparency and balance-sheet strength to perform across market environments. In this market, avoiding the losers may matter as much as finding the winners.
Jordan Lopez, CFA, Managing Director and Head of the High Yield Strategy Group, and Nick Burns, CFA, Senior Vice President, High Yield Co-Portfolio Manager, both of Payden & Rygel, a global asset management firm.
This material reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed. This material is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. Past performance is no guarantee of future results.
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© Payden & Rygel
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