Against the current: considering high yield as flows recede

Bottom line up top:

High yield investors ran for the exit. After a brief uptick in flows in August, the last two weeks have seen a renewed flood of money leaving the high yield asset class. Outflows totaled more than $9.6 billion over that period, equal to over 4% of the asset class’s total AUM. This marks one of the largest two-week outflows since the Covid induced panic in March 2020 (Figure 1). In our view, this dynamic does not represent a sea-change for high yield, as a slew of positive tailwinds should keep conditions calmer in the months and quarters ahead.

But they may not be taking in the whole picture. Recent outflows have been partially driven by concerns over rising interest rates. Now that the sharpest rate moves are likely behind us, we see much less scope for further acute outflows. At the same time, we expect the higher level of yields to lure in investors. Overall yields for the high yield index are now above 8.5%, a level that has previously induced investors to move back into the asset class. Even with these attractive yields, the overall quality of the market has improved, with more than half the asset class now rated BB, up from around 40% in 2010 and 35% in 2000. Further, interest coverage is at its highest level since before the Global Financial Crisis, and 75% of the high yield debt outstanding today is not due until after 2025. This should reduce the risk of default driven losses, which have historically been the main barrier to strong high yield performance.

Portfolio considerations:

Steadfast hawkishness challenges the asset allocator in all of us. With the U.S. Federal Reserve’s Lael Brainard vowing to fight inflation “as long as it takes,” and the European Central Bank’s 75-basis-point hike and hawkish guidance, it seems clear central bankers are resolved to combat inflation. But that means more restrictive policy and lower nominal economic growth. It’s hard to be bullish on equities with this backdrop.?

So how to generate total return while minimizing downside risk? U.S. high yield might be an out-of-consensus idea, and spreads could widen from current levels. But we believe equities are more vulnerable. Shifting from equity into credit could allow investors to access “growth risk,” with relatively less downside risk, while also benefiting from attractive yields. This is our “paid to wait” mantra. We prefer higher-quality issues across high yield: BB rated paper is still yielding 7%, and has a relatively lower historical default rate, further skewing the positive tradeoff versus equities.

Plus, the entry point looks quite attractive. In Figure 2, we compare the valuation metrics for U.S. high yield and U.S. equities and standardize the difference over time for ease of comparison. Relative to U.S. equities, U.S. high yield is currently priced at one of its more attractive points in recent history. On an absolute basis, the current level of yields has historically proved to be an enviable entry point. Yields hit these levels only six times in the last 20 years, and the subsequent 12-month total return averaged +15.3% in those instances. That’s almost double the average return over the same period of around +8%. Investors seeking to position portfolios for upside potential while limiting downside risk may find tapping credit over equities a compelling way to generate risk-adjusted total return.

For more on our views, click here .