Invesco: Our view on the high yield market

Factsheets: Invesco Bond Income Plus

 | Invesco Monthly Income Plus Fund (UK) 

Key takeaways

• Against a challenging backdrop, high yield bonds have outperformed investment grade and sovereign bonds so far this year.
• The rate of high yield issuance has collapsed against the current macro backdrop but, ultimately, high yield borrowers will have to come to terms with lenders and the market will reopen.
• There are much better yield opportunities now available, but the onus is on investors to focus on fundamental credit research. With an active approach, we believe we are well positioned.

The total return of the global high yield bond market in the first five months of 2022 was -9.0%.¹ This is poor by historical comparison. The return for the same period in 2020, encompassing the Covid crash, was only slightly worse at -10.4%. But the performance of the wider bond market gives some context. Even with these returns, high yield bonds have outperformed investment grade bonds (-10.8%²) and sovereign bonds (-13.1%³) in a broad-based bear market.

The sell-off was broad because its principal cause was a factor that affects all bonds – interest rates. Over the last few months, there has been a large increase in rate expectations. As recently as September, the Federal Funds Rate was 0.25% (upper bound) and the market was predicting that this would rise by just 13bps over the following year.

In the UK, Bank Rate was 0.1% and expected to rise 49bps. At the end of May, the market’s one year expectation was a Fed Funds Rate of 3.1% and a Bank Rate of 2.8%. This re-evaluation of the risk-free rate has driven a repricing right across the market, pushing up yields in corporate as well as sovereign bonds (see Figure 1).

Figure 1. Sterling bond market yields (%)

Source: Macrobond, May 2022

This change reflects a shift in central bank policy. Inflation is at multi-decade highs across the major developed economies. In response, central banks have had to show a commitment to tightening policy.

The importance of the rates factor in the sell-off in the high yield market is illustrated in Figure 2. In the past few months, the share of the total yield that is accounted for by interest rate risk (i.e. the total yield minus the credit spread) has risen quickly, following a period where interest rate risk was an unusually small share.

Figure 2. Global high yield market – credit spread compared to total yield

Source: Macrobond, May 2022

For well over a decade, the credibility of central banks’ price stability mandates has not been in focus. More often, policy has been aimed at stimulating demand and supporting risk markets through quantitative easing. Now, with inflation much higher, policymakers have much less room for such support. The bond market has to adjust to a level that reflects this.

High yield bonds are typically less sensitive to interest rates. Higher coupons and shorter maturities mean the market has lower duration. This helps to explain why the high yield market has outperformed sovereign bonds and investment grade over the last few months of rising rate expectations.

Inflation: what are the implications?

High yield bonds have more credit risk, meaning they are more sensitive to corporate earnings and therefore economic growth. The surge in inflation carries a threat to growth, as higher prices can dampen consumption. The war in Ukraine has exacerbated the inflationary problem and is also a threat to consumer confidence. In the period since the Russian invasion in late February, high yield has underperformed as credit spreads have widened in anticipation of lower growth and more credit/default risk.

All of this adds up to a less supportive environment for corporate borrowers. In recent months we have seen corporates react by stepping away from the market. The rate of high yield bond issuance has collapsed. A year ago, European currency high yield bond issuance was running at €10-14bn per month, leading to a record year for issuance of >€120bn. In March it was less than €2bn and in April just €0.2bn⁴. The market has essentially been closed, as borrowers wait and see if conditions will improve.

To a degree, the very high level of issuance in the low yield conditions of 2021 has enabled the pause this year. But it can’t last forever. High yield borrowers will have to come to terms with lenders and the market will reopen.

The outlook for high yield

The outlook for the market is mixed. Investors must be compensated for higher interest rates and for the risk to growth. However, the fundamentals of the market have strengthened in recent quarters. The leverage ratio has declined, earnings have increased and interest rate coverage has improved.

Investors will need to watch these metrics, as the impact of recent events on consumption and growth become clearer. There is already evidence of slower activity, with sentiment data in the US dipping (Figure 3). But the market is starting from relatively strong levels, giving some protection from a sharp rise in default risk. Moody’s forecast for the global high yield default rate in one year’s time is still low at 2.9%.

Figure 3. Regional manufacturing index

Source: Macrobond, May 2022

While the fundamentals may remain quite strong at the total market level, there is potential for parts of the market to underperform. Naturally, some businesses are more exposed to particular risks and our fundamental credit research must account for that. There is also some evidence that the balance of risk to reward is less generous in some areas of the market.

Deutsche Bank⁵ recently released a study on the rate of default implied by spreads across the global credit market. At the market level, spreads appear sufficient to compensate for relatively high levels of default. However, some parts of the high yield market – particularly the lower credit quality sectors – are more exposed. In both the EUR and USD markets, the spread on CCC is below the level that would compensate for average historical five-year default rates.

This echoes a point highlighted in our last market review. In the period since the 2020 sell-off, spreads across the high yield market compressed, with yield-hungry investors bidding up riskier cohorts. So, the extra yield for holding CCC-rated bonds, relative to B-rated, has diminished. As is clear in Figure 4, only a small amount of that compression has been unwound in the recent, weaker months.

Figure 4. European high yield spread compression (bps)

Source: Macrobond, May 2022

Compressed spreads are an indication of a market that has been less sensitive to the different risk profiles of companies. But we believe investors could become more discerning. In other words, how long before they start demanding a greater risk premium from companies which, under the pressures of the current economic environment, carry great risk?

There are much better yield opportunities now. We think this puts the onus on investors to focus on fundamental credit research. Our approach to investment focuses on credit research, supported by an experienced team of analysts. They look to identify the best opportunities from a broad universe. We believe this allows us to deliver a valuable service to the shareholders of Invesco Bond Income Plus, identifying and managing both the risks and the rewards.

Footnotes