The high yield bond market at the end of 2021

Managing bonds is always fun but can cause headaches too. We spend a lot of time thinking about what can go wrong; where there might be risks; and how these risks are reflected in market pricing. 

Viewed in this context, the high yield market has been kind in 2021, delivering positive returns with low volatility, strong demand and very few blow-ups. But a long period of positive returns poses different challenges as we head into 2022.

Steady returns and supportive policy have been the story of 2021

The European high yield market, represented by the ICE BofA European Currency High Yield Index, has delivered a modest positive return so far this year. There have been a few key things to call out:

1. To the end of October, the total return of the index was 3.1%. With little net change in yields, almost all of this has come from income.
2. Market volatility has been unusually low and returns were positive for eleven consecutive months to the end of August, one of the longest positive streaks in the 24-year history of this index.
3. Monthly returns in 2021 have also stayed in a tighter range than in any previous year (from +0.7% to -0.6%).
4. Spreads are tight and have also been very stable, with the total market spread narrowing gradually from 365bps in January to peak at 291bps in September. This is shown in Figure 1.

It’s clear that monetary policy and economic growth continue to support the market. Near-zero interest rates have stimulated risk-taking, pushing yield-seeking investors further into credit risk. This process has been strengthened by continuing programmes of quantitative easing. The combined demand from investors and central banks has reduced corporate financing costs.

As economic activity has risen, supported by stimulative fiscal policy, earnings growth has given fundamental support to the credit profile of high yield issuers. This is shown in data from JP Morgan[i], which demonstrates that leverage (net debt over earnings) in the European High Yield market has been falling for several quarters now.

At nearly six times earnings, this is still higher than the peak reached in the Global Financial Crisis. However, a lot of this is due to a small group of companies in industries that have faced relatively severe drops in earnings and have been particularly conservative in raising precautionary funding. 

Such examples include Travel, Leisure and Transport. If you look at the market without these companies then leverage has fallen to 4.5 times, which is around the pre-pandemic level.

This combination of policy support and fundamental improvement is reflected in defaults and credit ratings. The Moody’s measure of global defaults has fallen to 2.6% and is predicted to go as low as 1.6% in 2022. That would be the lowest since 2008 (Figure 2 below) and helps to justify the current low levels of yield and spread.

Compressed yields and narrowing spreads

Away from the tail of defaulting and distressed debt, the wider tide of credit rating changes has turned around. JP Morgan’s measure of ‘Ratings Drift’¹, which in the earnings collapse of 2020 plumbed depths unreached even in 2008, is now positive again and, at +9%, is not far from the peaks of recent cycles.

The range of yields available across the market has continued to compress as the risk premia demanded in the initial stages of the pandemic have been squeezed. Figure three shows the spread of B over BB as well as CCC over BB in 2021. Both have fallen as lower rated bonds have outperformed.

Similarly, the spread between companies with differing exposure to the pandemic has also narrowed. Barclays² judges that its chosen basket of directly exposed companies now yields just 38bps more than the rest of the market. The gap had peaked at 436bps in March 2020 and has averaged 176bps since the beginning of 2020. With the recovery in economic growth, the spread of cyclical over non-cyclical sectors has also fallen to a level below the pre-pandemic mark.

High demand for high yield

The high yield market is not only going from strength to strength, but is now also significantly larger with increased and more uniform valuations. Recovery of supply after the market disruption last March was remarkable and 2020 was ultimately a record year for high yield bond issuance. 

Figure 4 shows European issuance statistics. This year has been even stronger. As of the end of September, issuance has already comfortably exceeded whole-year 2020 levels on both a gross and net basis. There has also been a shift towards B issuance as the recovery has matured.

High yield borrowers have been able to access the capital markets very easily in 2021. Many of the factors that have brought us to this benign environment remain in place and indicators of growth are still positive. Progress on vaccine provision and the development of effective anti-viral therapeutics should limit the economic impact of future waves of covid infection. Policy remains directly supportive of the market and the major central banks are only taking gradual steps towards tapering quantitative easing.

Market expectations are that the default rate will remain very low and that supply will continue to be strong. JP Morgan predicts net European issuance in 2022 of €70bn³ – well above any year before 2021.

Could interest rates, inflation and demand prove to be headwinds?

There are risks to the positive outlook, with the most important being interest rates and market demand.

The high yield market is a relatively rate-insensitive part of the bond universe. Higher coupons and shorter maturities reduce duration and it is insulated by credit spread. But higher yields on low risk or risk-free assets have an impact right across the risk spectrum.

When government bond yields rose in the first quarter of 2021, with market expectations for interest rates rising in response to the strength of the economic recovery, the high yield market was not much affected. In fact, yields continued to fall through spread tightening.

However, the government yield sell-off in the last couple of months, driven by increasing inflation concern, has been different. High yield markets have been more correlated with governments (see Figure 5). If the market is sensitive to inflation risk, then the ability of high yield businesses to pass on inflation to consumers and protect the real value of their earnings will be an important factor to monitor.

Higher government (and investment grade corporate) yields tend to undermine demand for high yield. Yield-hungry investors have been happy to buy this year’s supply but yields may have to rise to find a level where demand meets the continued heavy supply expected in 2022. 

Flows data⁴ indicates that allocations to dedicated high yield funds have not been very strong in Europe this year. Demand has instead been buoyed by ‘off-benchmark’ allocations from the much larger UK investment grade fund universe. Such investments cannot grow indefinitely and could be reversed if investment grade yields rise.

Market dispersion may lead to opportunities for active investors

Overall, the high yield market faces into 2022 with a lot of wind in its sails. The macroeconomic environment is supportive, fundamentals are improving and the income available from high yield bonds remains a valuable alternative for investors. The lower market yield and the compression of valuations across the market that we’re now seeing are a natural consequence of the strong rally the market has experienced.

We have already become more cautious, at both the market and security level. We have been happy to turn down many new bonds in recent months when deals have not been creditor-friendly; have offered unappealing reward for the level of risk; or the terms have raised other red-flags for bond-selecting active investors.

In our view, this disciplined approach means we are well positioned for a period of more mixed returns and we would welcome the opportunities that may come from greater valuation dispersion across our market.