High-Yield Credit Is Still a Buy

Summary

• High-yield spreads were surprisingly muted during the past month’s volatility. We see this indicating the underlying strong fundamentals and look for spreads to keep grinding tighter.
• High yield should benefit from an improving default rate outlook and a decline in equity volatility in coming months.

Market Implications

• Investors can gain broad exposure to high yield through the HYG and JNK ETFs.

Amid the volatility and uncertainty sparked by a jump in the 10-year Treasury yield, equities and corporate credit markets hit turbulence in recent weeks (Chart 1). The surprise was that the high-yield market was so muted. Both investment-grade and high-yield spreads traded in a 15bp range – something quite unusual when volatility hits. The difference is that investment-grade spreads are near the wides of 2021, and high yield has recovered to the year’s tights. We see this robust performance indicating strong underlying fundamentals.

Still, we favour high-yield over investment-grade credit at this juncture. As long as markets are concerned about higher inflation and further increases in Treasury yields, investment grade will struggle to recover. The investment-grade sector has duration risk similar to the 10-year Treasury note; if Treasury rates rise further, investment-grade total returns will be hit even if credit spreads are little changed.

High-yield returns, however, are less correlated with rate risk. High yield has duration risk similar to the five-year Treasury. And the wider spread cushions against rate risk.

There are other reasons to favour high yield. One is the default rate outlook; the second is the prospect that equity volatility trends down in coming months.

Credit Spreads Are Tracking a 3% Default Rate

During relatively stable times, the high-yield spread tends to trade roughly in line with the default rate, whether measured on a 12-month or three-month trailing basis (Chart 2). When default rates spike as they did last spring, that relationship breaks down – the 12-month trailing default rate in particular lags badly. However, credit spreads are forward-looking and presumably trading more in line with the default rate outlook in coming months and quarters.

Moody’s is projecting the 12-month trailing default rate will fall to 4.7% by the fourth quarter. That would be consistent with credit spreads in the 450-500bp range. But high-yield spreads are 345bp.

In our view, the three-month trailing default rate better indicates the 2021 default rate outlook. It is now about 2.8%; we project it to settle near 3%. If that scenario happens, high-yield spreads could keep grinding tighter to the 300-325bp range.

Equity Volatility Likely to Fall

A second factor supporting high-yield spreads is the still relatively high level of the VIX equity volatility index (Chart 3). Note that historically the high yield spread tracks VIX closely. It is very unusual to see the current gap between the VIX and spread. We expect the VIX will gradually fall in coming months as the economy opens up. If this scenario happens, that should be a second factor helping spreads to grind tighter.

The alternative scenario, of course, is that the relatively high level of VIX indicates the high-yield spread rally is overdone and is at risk of repricing to something more like Moody’s default scenario.

Had the high-yield market reacted more nervously to the volatility and uncertainty of the past few weeks, we might be inclined to assign this latter scenario a higher weight.

Investors can gain exposure to the high-yield market through the HYG or JNK ETFs.