A selective approach is key in high yield in 2025

Jack Stephenson, Fixed Income Investment Specialist, spoke to Investment Week about US high yield and where we are finding opportunities.

How has high yield credit performed against the broader fixed income market?

The US high yield market has performed strongly and better than many people's expectations.  Over 2024, the US high yield market was up 8.2% while higher quality investment grade was up only 2.8%¹ .  The big surprise for many investors has been that it was the lower-rated part of high yield, CCC rated bonds, that drove performance in 2024 and 2023. The CCCs were up around 18% in 2024.¹

How do you see the evolving narrative of Fed rate cuts impacting the HY credit sector?

Currently, we think that some momentum towards lower rates is more than enough for most of the high yield market. However, when it comes to the more distressed part of the market, and particularly larger capital structures with over levered balance sheets and companies that are in somewhat of secular decline, these corporates would benefit from having bigger rate cut expectations and less interest expense to pay. 

What’s your strategy for 2025? What sectors are you overweight/underweight?

For short duration, our most defensive strategy, we're looking for predictable companies that generate free cash flow, pay down debt over time, have strong corporate liquidity, and show positive year-on-year results momentum.  For this approach, it matters less which sector that company is in as we assess companies through a bottom-up lens. 

Our longer duration, benchmark-type strategies are where we're combining that bottom-up process with some relative value considerations, seeking to outperform the benchmark with lower volatility, through a cycle. Currently, we are trying to get our yield closer to the benchmark without owning the distressed part of the market, which is not easy in today’s environment. Our duration, meanwhile, remains slightly lower than the benchmark given the heightened rates volatility we are still witnessing.

Across all our strategies, our bottom-up process tends to give us larger exposure to sectors like Services, Media and Technology (specifically Software), where we find more companies that fit our style of investing. Conversely, it leads to underweights in sectors like Energy, given the reliance of parts of the sector on volatile commodity prices – making them harder to predict.

In terms of sector trends, we’ve seen a small shift from a very strong consumer in the US last year and sectors related to that performed beyond people's expectations. As such, retail, hotels, tourism, leisure, and cruise lines are still performing very well.  However, there is more pressure coming into lower income consumers, so there is nuance around what is going to do well in the next phase of the cycle. 

In pockets of industrials and manufacturing we're looking to see some stabilisation in the recent capital expenditure decline that we've seen in those sectors where specific projects were put on hold while waiting for greater clarity on rates.

In media and telecoms, we’ve seen a real shift in the growth in fibre, away from traditional wireline companies.  Many of the large telecom companies had made significant investments in the past, but the recent hurdle to make a return on those investments was going to be a lot higher given the interest costs. M&A headlines have lifted the sector and recently we’ve had tailwinds not only from lower rates, but also announcements from Microsoft who, in partnership with BlackRock, are going to invest in data and AI centers. 

Historically, high yield has delivered equity-like returns with less volatility. Are high-yield bonds a good substitute for a portion of an equity allocation?

High yield can be broken down in many different ways. What we've done successfully is produce different strategies which not only target different investor risk-return appetites but also enable investors to shift between them depending on the outlook. 

The US Dynamic High Yield strategy is somewhere between the high yield and equity markets from a risk-return perspective, but aims to achieve half the volatility that you get in equities. 

I would also stress that high yield can provide important diversification qualities alongside equities or alongside longer duration parts of the portfolio. It’s not the market that people think it is; today's high yield market has improved significantly in quality. It's over 50% BBs and just 12% CCCs² , but even in the lower rated segment there are many solid businesses that may be rated CCC because they have a higher leverage, but that have strong operating trends and improving results. The broad US HY market today contains a number of companies that are in fact global leaders in their business lines, like Royal Caribbean, Carnival, Charter Communications and Hilton Hotels, which feel very comfortable as high yield companies because of the additional flexibility it can give them over their financing. 

Accessing meaningful pickup

The yield differential between what you can get in a market like high yield versus higher quality fixed income and cash has been growing and that is leading already to some reinvestment risk as those short-term cash rates are starting to decline.

With investment grade you've still got okay all-in yields but that differential with the cash rate is less than 100 basis points, so it's still not substantial.  Many investors could look at it and say why would I take that risk in corporate bonds when I can just continue to stay in cash?

In high yield you should get a meaningful pickup relative to cash and I think that's only going to increase as you start to see more interest rate cuts. 

What do you say to investors who are sitting on the sidelines due to tight spreads in the asset class?

There is a lot of cash that's looking for a home and there aren't that many asset classes that are offering comparatively attractive yields and carry as high yield does. Yes, spreads are tight, but they are there to compensate investors for default rates in the high yield market. Many investors look at spreads today and think: what compensation is that giving me?

Well, the default rate in the US high yield market is currently around 1.5% and if you exclude what we call distressed exchanges, it's closer to 0.5%³ ; so we believe that spreads are justifiably expensive and reflect a fundamental shift to a higher quality high yield market today than before the Global Financial Crisis.

Finally, I would emphasise that people often underestimate the power of carry in an asset class like high yield.  Although there may be drawdowns and sell-offs, they don't tend to last very long.

Appreciating that attractive income stream in high yield, which historically has driven returns, is the more predictable part of what we can control which is why we focus on fundamental security selection rather than really trying to time the markets from a price-return perspective. The power of that carry should lead to attractive annualised returns through time. Since 1987, the high yield index, on average had a 3-year calendar year return of about 8% annualised.⁴