CONTRIBUTORS
Bill Zox, CFA
Portfolio Manager
John McClain, CFA
Portfolio Manager
Jack Parker, CFA
Portfolio Manager
S. Blake Haxton, JD, CFA
High Yield Research Analyst
Dylan Herrmann, CFA
Client Portfolio Manager
The high yield market has been increasingly dislocated in recent months, meaning some bonds were down much more while others held up much better than we believe was warranted. After the huge declines following the Trump administration’s April 2 tariff announcement, these dislocations are even more extreme. At the close on April 8, the ICE BofA US High Yield Index spread was 457 basis points, the yield-to-worst was 8.63%, and the dollar price was close to 92 cents.
Investors and allocators have to be “comfortable being uncomfortable.” In periods of heightened volatility, the comfortable move has rarely been the right one over time. We believe high yield is the safest risk asset class, and now is the time for allocators to add or make a plan to add high yield. Furthermore, haven assets like Treasuries and other sovereign bonds could potentially struggle in a pronounced stagflation environment in which deficit reduction targets are missed.
High yield weathers well versus equities
Some allocators are inclined to sell high yield when they fear recession. We encourage those allocators to focus first on their equity exposure. In significant stock market declines, high yield typically draws down less than stocks and recovers faster. After giving up all of their post-election gains in late March, stocks have been in freefall since the Trump administration’s unexpectedly extreme tariff announcement. While high yield bonds also have been under pressure, they have held up much better than stocks on a total return basis. From the peak of the Russell 2000 Index on November 25, 2024, through April 8, 2025, the High Yield Index is down a modest -2.0% while the Russell 2000 is down -27.9% on a total return basis. From the peak of the S&P 500 Index on February 19, 2025, high yield has declined only -3.3% versus a -18.9% drawdown for the S&P 500 (see Exhibits 1 and 2).
The resilience of high yield bonds relates to their seniority in the capital structure, low duration, high income, and contractual maturity date. At just over 3 years, high yield duration is low compared to stocks and core fixed income and also compared to its own historical range of 4 to 4.5 years. The contractual maturity date of a bond leads to a “pull to par,” which means that as long as default is avoided, the holder gets 100 cents on the dollar at maturity or, in some cases, more when the bond is retired prior to maturity. High yield bonds can also generate meaningful current income that can be reinvested at higher yields when the market is weak.
As a result, high yield bonds are more tied to a company’s balance sheet. If the value of the business exceeds the face amount of the bonds, the business should be able to refinance the bonds so that the holder receives 100 cents on the dollar or more. Stocks more closely relate to the income and cash flow statements and the value that the market assigns to income and cash flows. This distinction was most apparent in the lost decade for the S&P 500, which was actually 11 years (see Exhibit 3). From the beginning of 2000 to the end of 2010, the S&P 500 compounded at less than one-half of 1% per year while the ICE BofA US High Yield Index compounded at over 7% per year. The S&P 500 did not catch up until the spring of 2021.
High yield versus leveraged loans and private credit
As floating-rate assets, leveraged loans and private credit have the wind at their back when the Federal Reserve is raising rates. When rate cuts are the focus, particularly due to a weakening economy, pressure will build on floating rate loans to below investment-grade companies. Lower rates mean lower yields on floating rate loans. In contrast, high yield bonds are fixed rate, and spread widening generally is cushioned by the decline in Treasury yields. From the February 19 peak in the S&P 500, the spread on the High Yield Index has widened by close to 200 basis points, yet the total return is down -3.3%, as of April 8, 2025. Some of that spread widening was cushioned by the 50-basis point decline in the 5-year Treasury yield since February 19.
Allocators still prefer CEOs and CFOs over politicians
The demand for low duration credit of any kind, including high yield, has been competitive since late 2023. This increased demand was met with muted net new supply as chief executive officers (CEO) and chief financial officers (CFO) focused more on preparing for potential recession and higher interest rates than aggressive capital allocation like debt-financed acquisitions, dividends, or stock buybacks. In effect, allocators want to bet on CEOs and CFOs rather than politicians. Inflows into high yield were high during 2024, even when spreads were narrow, because these allocations were strategic rather than tactical. We believe that in most cases these allocations were partial with the plan to add when spreads widen or yields increase. So far, that is what we have seen in 2025 as inflows into high yield have continued at competitive levels as spreads have widened.
Major changes in market structure create opportunities
Systematic, momentum, and passive investors have been increasingly influential in the high yield market, particularly in recent weeks. In a down market, assume there are two reasonably comparable bonds, but one is down one point and the other is down five points. What explains the four-point price dislocation? The systematic player is looking for weak small-cap stocks of companies that also have high yield bonds. Upon any fundamental hiccup, the systematic investor typically would short the stock and bonds, putting the company into a negative feedback loop. The stock is sold because the bonds are weak, and the bonds are sold because the stock is weak. Meanwhile, the passive player is a seller of both bonds equally to fund redemptions and replicate the benchmark. In this hypothetical example, the momentum player would short the bond that has sold off more because it is going down. Lastly, the active manager sells the bond that is down one point to buy the bond that is down five points. In recent weeks, however, the market has been dominated by the systematic, momentum, and passive players while the active managers have been less willing to step up.
Risk mitigation and opportunity identification
We are more cognizant of our exposure to the high yield bonds of public small-cap companies that have experienced fundamental hiccups. In our view, the prevalence of systematic, momentum, and passive investors in the high yield and equity markets in recent weeks has created dislocations and a negative feedback loop, particularly for companies with weak small-cap stocks that also have high yield bonds. In a situation like the current environment, we focus on risk mitigation and opportunity identification.
We have always preferred the transparency, price discovery, access to capital, and discipline of the public stock market. What we have found is that when a stock is down 25% to 60% in a quarter, the CEO’s family and friends, the Board, employees, customers, and suppliers all know it. Often, the CEO’s highest priority is to restore the confidence of the bond market to break the negative feedback loop of declining stock and bond prices. We believe this dynamic creates opportunities for active high yield investors. In contrast, we believe that CEOs of private companies are more likely to keep their foot on the accelerator because their stock valuation is not widely known. This thesis, which generally has served us well over time, will be tested in the coming quarters, but we are confident that it is justified.
In the middle of 2022, the High Yield Index bottomed at about a 600 basis-points spread and 9% yield. We believe that was a market that was priced for a very high probability of recession. We started to see capital from various sources, including some private equity capital, come into the high yield market. The High Yield Index has compounded at 8.2% since then. In late October of 2023, the High Yield Index was at about a 450 basis-points spread and 9.5% yield, and the market took off from there. The High Yield Index has compounded at 10.5% since then. We believe we are approaching a similar point today. Further, we continue to see opportunities, and we believe there are plenty of safe 7% bonds, lots of competitive 8% to 9% bonds, and some really interesting 10% to 12% bonds, which could have a materially higher internal rate of return. With the slowdown in earnings power, we find these yields compelling in an asset class that is tied to the balance sheet more than the income or cash flow statement like equities.
Nobody knows where current events will settle, but the financial markets, elected officials, the courts, public opinion, and plenty of other forces will come into play. This environment feels to us like one that leads to attractive returns for the long-term investor.
Definitions
The ICE BofA US High Yield Index tracks the performance of USD-denominated below investment grade corporate debt publicly issued in the major domestic markets.
The Russell 2000® Index, which is a subset of the Russell 3000® Index, measures the performance of the small-cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market capitalization and current index membership.
The Standard & Poor’s® 500 Index (S&P 500®) is a broad measure of U.S. domestic large cap stocks. The 500 stocks in this capitalization-weighted index are chosen based on industry representation, liquidity, and stability.
A floating-rate asset, also known as a “floater”, is an investment with interest payments that float or adjust periodically based upon a predetermined benchmark.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is no guarantee of future results.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.