Four reasons not to own high yield – and why they miss the mark

Why would an investor want to buy high-yield bonds now? Spreads look tight, risk-free rates already offer mid-single digit returns, tight monetary policy leads to investors taking risk off the table and equities look like they will offer better returns. So high yield seems like an obvious part of the market to avoid, right?

We disagree. Let’s go through each of the four statements above to explain why.

1. High-yield spreads are too tight

There are two elements here. The first is the abstract idea that a single measure of high yield ‘spread’ is representative of thousands of underlying instruments. Are we referring to Isabel Marant Group 8% 2028 notes with a spread of 1,462bps as being tight? Or maybe Drax 6.625% 2025 notes with a spread of 0bps? We do not own the index (just a few percent of it) and therefore the average is a meaningless concept to us.

The second is that spreads in high-yield bonds are not comparable to those in other fixed income markets. Unlike with government or investment grade bonds, for example, high-yield bonds have different potential redemption dates, and the timing of these – and the cash price paid – can have an enormous impact on spreads.

As an example, we own Penske Automotive Group September 2025 notes. These bonds currently trade at a spread to worst (the figure used in index ‘spread’ numbers) of 92bps over Treasuries. Now, it is a BB (meaning it is towards the higher quality end of the high-yield spectrum) with a $10 billion market cap, estimated to generate $900m of free cashflow this year, and the $550m 2025 bond is the first debt maturity, so that stated 92bps yield pickup over a 2025 Treasury looks fair.

However, these bonds are unlikely to see September 2025. Over the past year, the average high-yield bond has been redeemed 15 months before maturity¹. If we assume Penske’s bonds get redeemed 12 months early, the spread over Treasuries jumps to 850bps. That’s quite a difference from 92bps.

The number of bonds available below ‘par’ – and therefore with capital upside to an early redemption – has never been as high as today, outside of periods of extreme stress². And that neatly illustrates why the index spread levels for shorter-dated high-yield bonds are largely irrelevant in today’s market.

2. Risk-free rates are more attractive

It is true that risk-free rates look attractive today. The issue is that as time goes on, the opportunity cost from sitting in cash and cash equivalents rather than higher-yielding parts of the market compounds.

Let’s take an investor who bought US T-bills (short-dated US government bonds) the moment they passed a 3% yield (30 September 2022) and held them through to today.

They would have made a total return of 7.8% over this time. Not too shabby. But over the same period, our Artemis Funds (Lux) – Global High Yield Bond Fund delivered a total return of 19.3%³.

The missed carry from high-yield relative to risk-free rates over the period means that even if there were a significant market downturn from here, the investor who remained in cash the whole time would likely still end up worse off versus the one who remained in high-yield bonds.

3. Tight monetary policy leads to a risk-off environment

While tight monetary policy does cause investors to sell riskier assets, high-yield bonds tend to do well in these periods.

Since the beginning of the 1980s, there have been eight hiking cycles that ended in cutting cycles. The average one-year total return on US high yield from the time of the first cut has been +7.1%⁴. Put simply, the end of a hiking cycle (in other words, the start of a cutting cycle) tends to be good, not bad, for high yield.

4. Equities offer more attractive returns

Equities have had a great run of late. And as our head of fixed income Stephen Snowden likes to say, everyone should buy equity funds.

However, with yield levels where they are today, returns from our area of the market have historically been comparable to those from equities.

The US high-yield market currently yields 8.2%. Based on the US high-yield index and the MSCI World index, when yields exceed 8%, the average three-year annualised return on high yield has been 2.6 percentage points above that seen on equities.

I do not want to leave anyone thinking they should not own equities – they should – but high yield at these valuations offers a very nice complement to other portfolio assets from both a return, and a risk, perspective.

The opportunity available in high yield

There is a common thread running through what generates outperformance – looking at things a little differently and finding opportunities in areas where others simply do not bother to look. The high-yield market offers a huge opportunity for investors who are willing to do just this.

Ultimately, I think the question is not why should you own high-yield bonds at this point, but more why wouldn’t you?