High yield: spreads can be deceiving | Insight Investment

High yield credit spreads have trended close to their tightest levels since 2007. But all may not be as it seems. We believe investors might find compelling value in high yield by taking a closer look at the market.

Three reasons you might be wrong about high yield credit spreads

1) Default rates have trended below 1% per year
On average, US high yield index level default rates have averaged only 0.79% pa in the post-pandemic era, for a loss given default rate of just 53bp¹. This implies a significant realized yield premium versus BBB and investment grade corporates if these trends continue. Even if they don’t, we believe defaults would need to exceed historical averages to undermine the value proposition (Figure 1).

Figure 1: We believe yields on high yield corporates look attractive if defaults remain low or historically average¹

2) Structurally lower credit spreads may be justified
We suspect that we may be witnessing a paradigm shift in market structure. High yield markets are no longer primarily a vehicle for financing leveraged buy outs, as private equity buyers increasingly turn to private credit markets instead (Figure 2 left).

This is reducing the share of highly leveraged borrowers and thus potentially reducing default risks. At the same time, the credit quality of the universe has been improving over the years, with the BB share of outstanding debt rising (Figure 2 right).

Figure 2: The share of LBOs funded in the high yield market has been falling and the share of BBs has been rising²

Additionally, the rising adoption of credit portfolio trading has improved high yield liquidity, which we believe can translate to a lower illiquidity risk premium. Further, the market is larger and more diversified, doubling in size since the 2008 crisis.

3) Waiting for spreads to widen has not been as historically profitable as you might think
Although we believe the high yield market may justify tighter spreads, some investors continue to wait for a period of market volatility for an opportunity to purchase the asset class at wider spreads.

However, staying out of the market means potentially missing on significant carry from income and principal payments while they wait.

We back-tested several hypothetical high yield range trading strategies, each designed to buy spreads at historically wide thresholds and sell into cash at historically tight triggers. Intriguingly, almost all of them underperformed the high yield index, even before factoring in transaction costs (Figure 3).

Figure 3: Buying and holding the high yield index may be superior to trading in and out of it³

Conclusion: In high yield, time in the market beats timing the market

In our view, with the US economy on sound footing, and the default environment potentially benign as a result,  all-in yields offer potentially ample compensation for default and spread widening risks. Therefore, we believe investors should consider a closer look at high yield. In particular, we believe investors should consider a systematic approach that can aim to overcome transaction costs and target reliable model based beta and alpha.

Figure 4: Reliably extracting available value from high yield may be achievable with a systematic approach⁴