Credit markets have delivered strong returns over the past several quarters, amid positive economic data, declining inflation, and a resilient labor market. This improving economic backdrop has led to tighter credit spreads, which now reside near multi-year lows. With spreads at these levels, investors may be wondering whether the high yield asset class can continue to deliver strong returns at current valuations.

Here, we address three questions that we have been getting from clients about current conditions in the high yield market, how they influence future prospects for the asset class, and related topics.

Question 1: “Why should I buy high yield with spreads at current levels?”

We know that credit spreads compensate investors for several factors: the prospect of loss given the possibility of default and, broadly, additional risks like portfolio liquidity, capital structure complexity, and various operational changes. Traditionally, investors prefer to invest in credit when spreads are wider, allowing for potential price appreciation in the event spreads tighten.

While current high yield spreads of approximately 330 basis points (bps) are not wide by historical measures, we believe it is just as important to look at the combination of the relatively high “all-in” yields and low dollar prices that the asset class currently offers. The starting yield (represented by yield-to-worst) of the benchmark ICE BofA U.S. High Yield Index is just below 8%, which is close to 10-year highs—levels that historically have signaled strong forward returns for the asset class.

At the same time, prices for high yield bonds (dollar prices) remain at a meaningful discount to par, giving investors the potential for additional return from price appreciation. This is particularly notable as prices have not been discounted to this magnitude, at similar levels of credit spreads, in the past.

Question 2: “Corporate defaults have been rising; are they going to continue to move higher?”

High yield default rates have risen modestly over the past two years, as issuers have had to face higher interest rates and tighter financial conditions. However, default rates are still around the historical average of approximately 3%. In fact, the “distressed ratio,” as defined by the proportion of the high yield market trading at a credit spread of 1,000 bps or higher, is between 6%-7% today. This is significant because, historically, the 12-month forward default rate has typically ranged between 35%-45% of the starting distress ratio. In this case, that would imply a default rate between 2.5%-3.0% for the year ahead—a touch lower than the historical average—and largely priced into current market valuations.

One reason why defaults may be less prevalent is that credit fundamentals for high yield issuers remain relatively healthy. Specifically, leverage remains historically low, and interest coverage continues to be near multi-year highs, albeit modestly weakening from all-time high levels. Looking forward, if inflation remains elevated, this may help balance sheet quality by reducing companies’ debt levels (on an inflation-adjusted basis). Additionally, the composition of today’s high yield bond market remains tilted toward higher-quality issuers than in the past, with the percentage of CCC-rated bonds in the index at nearly historical lows.

Question 3: “There is a significant amount of bonds maturing in the next few years. Will that pose a challenge to high yield issuers who need to refinance?”

Several recent news reports have discussed the so-called “maturity wall” of debt coming due in the next several years and the implications for credit markets. Many high yield companies were able to refinance existing debt at low rates in 2020 and 2021, extending outstanding liabilities to later due dates. While a large amount of this debt is maturing in the next two years and will likely cause high yield issuers to refinance into higher rates, most of this debt was issued by higher-quality BB- and B-rated issuers. We believe these issuers, especially BBs, tend to have more flexibility regarding refinancing as they typically have large capital structures, more consistent access to markets, and easier access to alternate avenues of financing in periods of stress. Additionally, capital markets have been active recently, providing issuers access better access to funding.

– While current high yield bond spreads are tight by historical measures, all-in yields near 8% have historically translated into attractive forward returns for investors.

– The percentage of the high yield market that is “distressed” remains low, suggesting a manageable forward default rate.

– Most of the high yield debt coming due in the next two years is from higher-quality issuers who generally have more flexibility when addressing near-term liabilities.