High-Yield Opportunity Persists, Despite Tight Spreads

06 September 2024

3 min read

Will Smith, CFA| Director—US High Yield

AJ Rivers, CFA, FRM, CAIA| Head—US Retail Fixed Income Business Development

High-yield investors put off by today’s narrow spreads could be missing out.

With high-yield credit spreads hovering near all-time lows, some investors may be tempted to sit on the sidelines until spreads have widened before investing. We think that could be a mistake. In fact, we see a compelling case for investing in the high-yield market today, despite narrow spreads. Here’s why.

1. Spreads Are Tight Because of Good News

The biggest reason that spreads are so narrow today is that economic news has been good. Sustained economic growth has made the possibility of recession seem more remote. Strong fundamentals also play a role, as companies have fortified their balance sheets and locked in lower interest expenses in the years since the COVID-19 pandemic. As a result, defaults have been modest, running below their historical averages—and below Street expectations.

Meanwhile, attractive yields have stoked demand in the global high-yield market as investors try to capitalize on higher potential returns and lower perceived risks. By contrast, on the supply front, companies have focused more on reducing debt than on using it for growth or acquisitions. As a result, demand has been outstripping supply, creating a favorable technical backdrop that supports prices and keeps spreads tight.

Debt reduction has also caused the average maturity of the Bloomberg US Corporate High Yield Index to shorten to record lows (Display). Consequently, both the index’s average duration and its “spread duration”—the sector’s price sensitivity to changes in spread levels—are below historical averages.

The High-Yield Market’s Average Maturity Has Shortened Dramatically

Bloomberg US Corporate High Yield Index: Average Maturity (Years)

Since its peak at nearly 10 years in 1992, average maturity has fallen to less than 5 years today.

Historical analysis does not guarantee future results.
Through August 29, 2024
Source: Bloomberg

2. Tight Spreads Have Tended to Be “Sticky”

If history is a guide, high-yield spreads could stay in their current range for some time. Since the mid-90s, tight spreads have remained tight for more than two years, on average (Display).

On Average, Spreads Have Remained Tight for 28 Months

Bloomberg US Corporate High Yield Index: Spread (Basis Points)

Since 1994, periods when spreads ranged between 400 bps and long-term averages lasted 12 to 56 months.

Historical analysis does not guarantee future results.
Highlighted periods begin when spreads fall below 400 bps and end when spreads rise above the long-term average spread of 517 bps.
Through June 30, 2024
Source: Bloomberg and AllianceBernstein (AB)

That’s a long time for sidelined investors to pass up attractive income and return potential. Even a patient investor may find they’ve waited for nothing. (And on those occasions when spreads do blow out, not many investors feel comfortable adding risk when spreads are exceptionally wide, indicating a risk-off environment.)

Further, since 1994, when spreads ranged between 300 and 400 basis points, ensuing returns were strong, averaging roughly 6.6% (Display). In our analysis, that’s because macro factors and overall yield levels hold more sway than spreads.

Narrow Spreads Haven’t Always Translated into Low Returns

Bloomberg US Corporate High Yield Index: Average One-Year Forward Return by Spread Bucket

When spreads ranged from 300-400 bps, returns over the next year averaged 6.6%--higher than any spreads range below 600.

Historical analysis does not guarantee future results.
Spreads are option adjusted.
January 1994 through June 30, 2024
Source: Bloomberg and AB

3. Yields Are Compellingly High

While spreads are relatively low, yields on high-yield bonds are higher than they’ve been in years. And historically, yield has been a much better predictor of return than spread has been. History shows that the sector’s yield to worst has been an excellent proxy for return over the next three to five years, in all kinds of markets (Display). With today’s yield to worst at 7.3%, the potential return appears sizable.

Yield to Worst Has Historically Been a Strong Predictor of Future Returns

Across all kinds of markets, five-year forward returns have closely paralleled starting yield to worst.

Past performance and current analysis do not guarantee future results.
YTW: yield to worst; GFC: global financial crisis
As of August 31, 2024
Source: Bloomberg and AB

When It Comes to Risk, Context Matters

Some investors may nonetheless be leery of potential spread widening. Because spread widening typically occurs during market corrections and in risk-off environments, it’s important to consider risk-taking in the context of the larger portfolio. That’s especially the case for investors who are overweight equities but underweight credit.

Historically, high yield has delivered equity-like returns with roughly half the volatility. During major sell-offs such as the dot-com crash, the global financial crisis and the COVID-19 pandemic, equity returns declined more sharply than high-yield returns, and high-yield recovered more quickly (Display). In our view, that makes high-yield bonds a prudent substitute for a portion of an equity allocation.

High Yield Has Outperformed Equities During Major Sell-Offs

Total Return (Percent)

During the past three major crises, high yield declined less, then recovered sooner and more dramatically than equities.

Historical analysis does not guarantee future results.
High yield is represented by the Bloomberg US Corporate High Yield Index; equities are represented by the S&P 500.
As of August 31, 2024
Source: Bloomberg, S&P and AB

Of course, spreads may move in either direction, not just wider. Though GDP growth is slowing, we continue to view a recession as unlikely, given the economy’s underlying strength coming into the policy cycle. If the Federal Reserve successfully avoids a recession, it’s possible that spreads could tighten even further, giving a near-term boost to the high-yield market.

Regardless, positive economic news, strong fundamentals, sticky spread trends and compelling yield levels make it, in our view, worth giving a green light to investing in high yield today.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Will Smith, CFA

Will Smith is a Senior Vice President and Director of US High Yield Credit. He is also a member of the High Income, Global High Yield, Limited Duration High Income, Short Duration High Yield and European High Yield portfolio-management teams. Smith designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. He leads the monthly High Yield portfolio-construction meeting, and is a member of the Credit Research Review Committee, which determines investment policy for the firm’s credit-related portfolios. Smith has authored several papers and blogs on high-yield investing, including one on the importance of using a probability-based framework to build better portfolios. He joined AB in 2012, and spent 2014 in London as part of the European High Yield portfolio-management team. Smith started his career with UBS Investment Bank, working as an analyst with the Credit Risk team and then later on the Fixed Income sales and trading desk. He holds a BA in economics from Boston College and is a CFA charterholder. Location: Nashville

AJ Rivers, CFA, FRM, CAIA

AJ Rivers is a Senior Vice President and Head of US Retail Fixed Income Business Development. Prior to joining AB in 2022, he was the director of Product Strategy at Lord Abbett. Throughout his career, Rivers has been directly involved in the rates and credit markets, and has directed the product development and competitive positioning of investment strategies in traditional and alternative assets. He has held roles in trading, risk management, portfolio analytics and product strategy. Rivers attended the McDonough School of Business at Georgetown University and graduated from the University at Buffalo for undergrad. He is a CFA charterholder, a Financial Risk Manager (FRM) and a Chartered Alternative Investment Analyst (CAIA). Location: Nashville

High-Yield Opportunity Persists, Despite Tight Spreads

1. Spreads Are Tight Because of Good News

2. Tight Spreads Have Tended to Be “Sticky”

3. Yields Are Compellingly High

When It Comes to Risk, Context Matters

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