Key Points

– Historically, short-duration high yield has provided a better risk-adjusted return to the broad high yield market.

– Examining the asset class during previous easing cycles shows that short-duration high yield kept pace or outperformed the full-duration high yield market.

– Today’s yield curve normalization is more reflective of a return to trend like growth and inflation, and not a more serious downturn, in our view. Credit can perform just fine given the backdrop.

With a string of softer inflation and labor market readings this past month, the case for Fed easing starting with the September meetings has become stronger. As a result, the yield curve has further normalized from its inversion that has otherwise persisted since mid-2022, as measured by the yield difference between two-year and 10-year U.S. Treasuries. Over this period, many fixed-income investors had taken advantage of the opportunity to shorten portfolio duration while still achieving equal or better fixed-income credit yields than available further out the curve.

The growth in investors’ allocation to short-duration high yield strategies (as well as bank loans, to a lesser extent) over the last couple of years is no exception. But with the yield curve set to normalize, and potentially further steepen from here, many investors are left wondering how short-duration approaches in leveraged credit might perform once the Fed starts to ease. Is this the time to extend duration in this credit asset class? Or exit high yield outright?

From Figure 1, we can compare the risk-adjusted returns of full-duration and short-duration approaches to the U.S. high yield market over the long term. When compared to either a full-duration BB-/B-rated approach or a more inclusive market opportunity that includes CCC-rated bonds, short-duration high yield historically provided similar annualized returns with approximately 25% lower volatility. Of course, during that period, the Fed had undertaken four separate easing campaigns of various magnitudes.

As noted, the period since 1996 has witnessed a variety of macroeconomic environments, four Fed easing campaigns, and differing starting fixed-income yields on offer. That provides a rich set of data points to compare leveraged credit performance during easing cycles. In Figure 2, we present four different time event studies, each comparing the ensuing two-year cumulative total return of short-duration high yield, bank loan, and high yield indices, starting three months prior to the first Fed easing of each respective cycle.

Some observations follow:

2001 Cycle: Short-duration high yield outperforms materially. The early 2000s recession witnessed an extended period of elevated default activity, and yet short-duration high yield dominated the entire period, despite credit concerns across the quality spectrum brought about by the length of the recession. Of the four easing cycles we can study, this period comes closest to a “garden-variety” recession not otherwise associated with a banking crisis or external bolt from the blue, such as the Global Financial Crisis (GFC) and COVID-19 pandemic.

2007 Cycle: A similar outperformance by short-duration high yield. The 2007-2009 period differed materially from the early 2000s just based on the intensity of the GFC and follow-on coordination of fiscal, monetary, and regulatory responses, and yet the outcome was the same. Default and distress were much higher during 2008 when compared to the early 2000s, with the trailing 12-month default rate spiking to 16.3% but quickly falling thereafter, according to J.P. Morgan data¹. The portion of the high yield market trading at distressed levels, as measured by the proportion of the high yield market trading at a credit spread of 1,000 basis points or higher, during that same period spiked to 90% in late 2008.

2019 (and 2020) Cycles: Splitting the difference between full-duration high yield and bank loans. The quick pivot by the Fed in 2019, given the intensity of the risk markets’ turn lower in the fourth quarter of 2018, saw high yield recovering well through 2019 as a recession was avoided, only to be met with the COVID-19 pandemic in early 2020. Admittedly full-duration high yield ultimately did modestly outperform over the two-year periods following the 2019 and 2020 easing campaigns, as the Fed dropped its target policy rate to 0% in early 2020 in response to the global pandemic. But short duration kept pace or outperformed bank loans through the entire period due to its incremental duration exposure, or increased sensitivity to changes in interest rates.

What Makes this Potential Easing Cycle Different?

Looking back to the four easing cycles of the past 20+ years, it’s hard to find a true parallel to the easing cycle we may be about to embark upon. Each of these prior cycles represented the Fed responding to a crisis or material economic slowdown already in the making. While we continue to be vigilant for signs of subpar growth by monitoring high frequency data, we characterize the current easing cycle to be more of a “normalization” of credit and monetary policy conditions rather than the need to proactively mitigate the impact of an outright recession or crisis already in motion. That also argues for the potential for a less aggressive easing cycle ahead compared to the ones studied above.

There are a couple of other conditions that may continue to favor shorter-duration exposure, while still being supportive of high yield over other higher-rated fixed income:

– The recency of the inflation threat and long-tailed structural economic changes, such as onshoring of supply chains, spending on energy transition initiatives, and demographic shifts that may be pro-inflationary, could keep the threat of higher-for-longer rates a reality in most investors’ minds. Additionally, the potential for inflationary cycles to last longer than many might expect could result in a steeper yield curve that may favor shorter-duration fixed-income approaches. Investors typically look to be compensated for inflation volatility by demanding term premium—compensation for longer-term interest-rate uncertainty—typically resulting in an upward sloping Treasury yield curve. During the period of quantitative easing, this premium evaporated, but we see reasons for it to emerge again now.

– Relative to the entry point of other easing cycles, credit fundamentals and the quality of high yield issuers’ balance sheets in aggregate are quite different today. Specifically, balance sheet leverage and interest coverage ratios remain close to their historic best levels, according to J.P. Morgan², and issuers remain exceptionally focused on refinancing over issuing debt for mergers and acquisitions (M&A), capital spending, and debt-financed share buybacks and dividends that are more equity-investor friendly. Issuers have also exploited robust capital market liquidity to push forward maturities through 2026 to 2027 and beyond. To the extent investors worry about upcoming maturities as a trigger to a more intense default wave, we don’t see those conditions in place.

Summing Up

Every monetary policy cycle is different, but history can serve as a guide. Despite the recent flares of volatility, our base case remains one of credit-supportive macroeconomic growth buttressing corporates’ ongoing fiscal discipline. As the yield curve normalizes and regains an upward sloping shape, we find the ingredients for attractive risk-adjusted returns in short-duration high yield firmly in place, consistent with the observations from prior easing cycles.