Overview
The first months of 2024 have left investors in fixed income strategies facing an increasingly vexing dilemma. Yields are far higher than at any point since the Global Financial Crisis and interest in both European and US high yield has picked up. Attendance at last month’s annual JP Morgan Global High Yield conference totalled over 1,800 investors, all on the hunt for income. That said, the crowds have brought spread levels for these asset classes to the tighter end of the range for the last decade. Are investors in danger of overpaying? We don’t think so.
At Fidelity International we monitor a proprietary metric that our quant team refers to as the ‘wipeout yield’. This metric is calculated as the yield to maturity of an index divided by its effective duration. It’s a simplified calculation that isolates the yield rise that would lead to a capital loss that wipes out a year’s ‘carry’ (defined as the index’s yield to maturity).[1]
As per the below chart, the latest update of the wipeout yield indicator for US HY shows it at its widest level in more than a decade. So while spreads have tightened, the overall protection implicit in current yields means it would take a substantial 240 basis point increase in yields (either through spread widening or US treasury rates increase) for a year’s worth of carry (currently at 7.85 per cent) to be wiped out.
That premium is higher than what was available in the worst days of the pandemic when markets were pricing in a much larger increase in defaults, or during the very volatile period for interest rates that followed the US presidential election in 2016. Why? Because over the last few years US treasury yields have been driven materially higher than in those previous two instances, making the impact of a change in spreads on overall returns less influential. US HY index yields were at 3.8 per cent in mid-2021, but, thanks mainly to the surge in benchmark treasury yields, they currently stand at just over 7.8 per cent.
The future direction of spreads is difficult to predict - who foresaw the tightening we’ve seen in the last year? It’s widely accepted that spreads are already tight but the boom in investor interest for high yield - given increased probabilities of a soft landing and potential Fed cuts - may well tighten them further. At the same time, we could see some companies struggle to sustain their capital structures in a high interest rate environment, leading to an uptick in defaults, widening spreads.
Whatever the case, the wipeout yield suggests that in an environment where defaults are expected to be contained, spread direction might not matter as much for total returns. Headline yields on US companies offer a substantial cushion, providing more protection for investors than some might fear.
[1] This metric does not take into account elements such as actual losses due to defaults.
