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Fixed Income Blog

Will High Yield Bonds Shine As Interest Rates Fall?

13 December 2024
2 min read

In the past couple of years, many investors opted for cash savings or money-market funds rather than bonds, while global central banks, including the US Federal Reserve, were raising rates rapidly in a bid to tame inflation. But with major central banks now changing course—pivoting towards a more accommodative stance amid easing inflation—due to growth concerns, is there room for high yield (HY) bonds to perform well?

 

Notable Numbers 

2%
US HY Median Default Rate

 

US HY bond defaults, at 0.9%, remain below their long-term average of 2% 1. We expect defaults to increase in both the US and Europe over the next 12 months if the global economy slows.

7%
Compelling Yield to Worst

 

Yield to Worst (YTW) 2 on HY bonds as of 30 September 2024 are higher than they’ve been in years. YTW has historically foreshadowed future returns. 

28
Months

 

Historically, HY spreads 3 can stay at tight levels for long periods, at an average of 28 months. As such, this may make it difficult for those trying to time when to enter the bond market.  

Current Market Outlook

 

1. Spreads are tight, but yields are high

Spreads—a proxy for the risk of default—have narrowed, but that’s because they reflect investors’ belief that the Fed will succeed in taming inflation without triggering a recession, in which some companies would struggle to repay their debts.

Despite the tight spreads, the yield on the high yield index stood at 6.99% 4 as of 30 September 2024 — above the 50th percentile over the last 10 years. If the US economy slows without a recession, we believe HY should continue to do well. That said, investors should remain cautious, as a significant economic slowdown could challenge the current spread environment. The key is maintaining quality exposure to credit alongside duration, while avoiding the temptation to chase yield in lower-quality segments.

2. Fundamentals remain supportive of HY bonds

Although HY bond fundamentals have softened, they are still robust. Overall market quality has improved, with higher quality debt (BB and B-rated bonds) making up a much larger portion (87%) of the Bloomberg US Corporate High Yield Index 5 than before the global financial crisis in 2007.  

Furthermore, historical data shows that almost 80% of defaults tend to be concentrated in CCC-rated bonds, compared with higher quality debt 5. With market quality improving, defaults could be avoided, and that has historically led to better outcome.

As interest rates start to fall, corporate issuers should also benefit from lower financing costs, improved cash flows, and stronger bond demand.

3. Opportunities for Potential Returns  

Historically, HY has delivered equity-like returns with roughly half the volatility 6. During previous major selloffs such as the dot-com crash, global financial crisis and the pandemic, equity returns fell more than high-yield returns, while high-yield rebounded faster. As such HY bonds can offer opportunities for investors seeking returns. That said, investors should also be mindful that investing in HY bonds involves a higher level of risk.

Sources:

1 Current analysis and forecasts do not guarantee future results.
US HY bonds are represented by Bloomberg US Corporate High Yield Index. US average from 1998 through September 30, 2024. Source: J.P. Morgan and AB
2 Past performance and historical analysis do not guarantee future results.
Yield to worst is the lowest potential yield that a bond can generate without the issuer defaulting.  Yield to worst, HY bonds and spreads are represented by Bloomberg US Corporate High Yield Index
As of September 30, 2024. Source: Bloomberg and AB
3 Past performance and historical analysis do not guarantee future results.
Based on Bloomberg US Corporate High Yield Index. Long-term average spread from 1994 through September 30, 2024. Source: Bloomberg and AB
4 Past performance and historical analysis do not guarantee future results.
High yield represented by Bloomberg US Corporate High Yield Index. As of September 30, 2024. Source: Bloomberg, J.P. Morgan and AB
5 Historical analysis does not guarantee future results.
Rating weights represented by quality buckets within the Bloomberg US Corporate High Yield Index; BB and B-rated bonds make up 87% of index, CCC and below rated bonds make up 13%. As of September 30, 2024.
Default rating based on credit rating one year prior to default. Based on Bloomberg US High Yield Index from January 1998 to April 30, 2023
Source: Bloomberg, Moody's Investors Service and AB
6 Past performance and historical analysis do not guarantee future results.
US HY is represented by Bloomberg US Corporate High Yield Index; Equity is represented by S&P 500. HY historical returns and volatility from July 1, 1983 to December 2023; Equity historical returns and volatility from January 1, 1957 to December 2023. Based on monthly returns. Source: Bloomberg, S&P and AB

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