Overturning the yields vs. spreads conundrum
When it comes to high yield bonds, many investors have grappled with the optimal time to add exposure. Yields above 8% look attractive, however spreads around long-term averages and looming recession risk give many investors pause for thought. While macro headwinds persist, and it is right to be cautious, long-term investors mustn't lose sight of the bigger picture. Yes, it is likely that spreads are biased towards widening in the short term, as there is little room for substantial tightening after the rally in 2023. However, we believe current yields in the global high yield market present a relatively rare opportunity for long-term investors to generate above-average total returns.
Past performance doesn't predict future returns, but can yields?
The attractiveness of an asset class can be evaluated using various metrics including yields, spreads, expected returns, etc. Although each metric may provide a different signal, the starting yield-to-worst tends to be a reasonable estimate of the forward five-year annualised returns. As shown below, this relationship has generally held true across various time periods. In both strong and weak economic environments, as well as periods with tight and wide high yield spread levels, the starting yield-to-worst has been close to the subsequent annualised five-year return.
Starting yields have historically been similar to five-year returns
ICE BofA Global High Yield Index monthly YTW and forward five-year returns
Source: Aegon AM and Bloomberg. Based on monthly ICE BofA Global High Yield (HW00) index data and includes the index YTW and forward five-year annualised return in local currency for certain time periods.
Yields above 8% present compelling long-term return potential
With a starting yield above 8% on the global high yield index*, we think high yield bonds look attractive for long-term investors, provided they can withstand some short-term volatility. As we all know, markets do not move in a straight line. Many timeframes shown above were accompanied by short-term volatility within the five-year period. However, high yield bonds benefit from higher coupons and enhanced income, which can help cushion against spread movements.
In this environment, we believe long-term investors should remain focused on the bigger picture as they balance caution and optimism. Over the long term, the structural case for high yield remains intact with the potential for equity-like returns and lower volatility. For those investors that want to be more tactical, we expect modest spread widening will present opportunities to add high yield exposure in the year ahead. However, wider spread environments have historically been short-lived, requiring investors to act quickly. For that reason, we believe it is time in the market, not timing the market, that matters most in high yield. Markets may be volatile in the short term, but we think high yield looks attractive for investors with a longer time horizon.
* Source: Bloomberg. Yield to worst on the ICE BofA Global High Yield Index was 8.7% as of 20 November 2023.
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