January 13, 2021

Spreads Have Rallied but Be Careful Fading High Yield Bonds

Profile picture for user David Jackson
David Jackson, CFA
Sr. Portfolio Manager

High yield bonds still offer attractive returns despite recent spread compression.

Since our last comment on high yield spreads the market recovered, closing 2020 at a record low yield to worst (“YTW”) of 4.25%. Despite low yields, high yield spreads finished the year at +392 bps versus treasuries, below their long-term average but still well above their historic low of +251 bps witnessed in May 2007.

While there is not a large sample set of instances in history we can examine when high yield spreads broke through the +400 bp level, today’s setup is reminiscent of the recovery following the 2015 oil price crash. Spreads later broke through +400 in February 2017 and from that point the high yield market went on to produce an extended period of coupon clipping returns.


In addition to support from recent history, high yield bonds currently benefit from an improving economy, demand from crossover buyers, and Fed support. We offer perspective on each below. Investors holding the preconception that high yield is fully valued after the recent run-up should take note.

Bouncing Back

The COVID-19 vaccine is a game changer. As the public gains access to this life-saving medicine the global population will soon reach herd immunity, enabling economies to reopen and return to normal function. The US consumer emerges from the last year on lock down with record high net worth and additional fiscal stimulus on the way. This will unleash pent up demand for goods and services.

Meanwhile robust capital market conditions have provided for a record wave of high yield refinancing. Terming out debt and lowering interest expense will remain a prevalent new year theme. This combination of a reopening economy, rebounding consumer spending, and balance sheet repair point to a material decline in credit defaults going forward.

Value is Relative

High yield bonds are an attractive complement to investment grade fixed income portfolios, as evidenced by the elevated spread premium between BB and BBB rated bonds compared with pre-crisis levels. On December 31, 2019 before the market collapse, BB bond spreads traded +86 bps wide of BBB spreads. January 11th, the discount is nearly double, standing at +156 bps, or +70 bps greater than it was pre-COVID (Exhibit 2). Furthermore, the effective duration of double B bonds (4.3 years) is roughly half that of triple B’s (8.1 years).



With triple B bond yields at a meager 2% and treasury rates breaking out post news of a Democratic sweep, this creates strong incentive for investment grade buyers in search of yield and concerned about duration to reach for BBs. This setup also creates a strong catalyst for compression between BB and investment grade spreads.

Whatever It Takes

As Penn previously discussed the Fed’s extraordinary measures taken last year proved they would do whatever it takes to prevent a financial system crash. High yield bonds continue to benefit from direct Fed support. As of its most recent disclosure the Fed owns $5.0b in face value of individual corporate bonds, with BBB and BB rated bonds making up 56% and 3% of those holdings, respectively. While the dollar value of bonds purchased is small in the context of the overall corporate bond market, the significance of the central bank’s direct support cannot be overstated.

 Together with the Fed’s more accommodative mandate “to achieve inflation moderately above 2% for some time”, the central bank maintains cover to aggressively intervene if the recovery falls off course. As always, we would caution investors fight the Fed at your own peril.


A PDF version of this report can be found here.


The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Under no circumstances should this information be construed as a recommendation or advice. The views expressed herein reflect the professional opinions of the portfolio managers and are subject to change. Penn Capital does not accept any liability for losses either direct or consequential caused by the use of, or reliance upon, this information. These views are subject to change at any time and they do not guarantee future performance of the markets. Investing in the stock market involves gains and losses and may not be suitable for all investors. Investors have the opportunity for losses as well as profits.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Penn Capital), or any non-investment related content, made reference to directly or indirectly contained within this commentary be suitable for your portfolio or individual situation, or prove successful. Comparisons to indices are inherently unreliable indicators of future performance. The strategies used to generate the performance vary from those used to generate the returns depicted in the benchmarks. Penn Capital makes no representation as to the methodology used to generate the benchmark returns. Portfolio holdings are subject change and may or may not be held by one or more Penn Capital portfolios from time to time. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall portfolio rebalancing.
Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Index performance does not reflect deductions for fees, expenses or taxes. Benchmark returns are not covered by the report of independent verifiers. Note that comparing the performance to a different index might have materially different results than those shown. The Russell 2000 Value Index is comprised of the 2,000 smallest companies in the value sector of the Russell 3000 Index. The Russell 1000 Growth Index is comprised of the 1,000 largest companies in the growth sector of the Russell 3000 Index. The Russell 2000 Index is comprised of the 2,000 smallest companies in the Russell 3000 Index, representing approximately 11% of the Russell 3000 total market capitalization. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The MSCI ACWI Ex-US Index is a market-capitalization-weighted index and is designed to provide a broad measure of stock performance throughout the world, with the exception of US-based companies and includes both developed and emerging markets. The Russell 1000 Value Index measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The MSCI Emerging Markets Index captures large and mid cap representation across 26 Emerging Markets countries and covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI ESG Leaders Index uses a best-in-class approach by only selecting companies that have the highest MSCI ESG Ratings. They are free float-adjusted market capitalization weighted indexes designed to represent the performance of companies that have favorable ESG profiles compared to industry peers. Overall the indexes target a 50% sector representation vs. the parent index. The MSCI Momentum Index aims to reflect the performance of an equity momentum strategy by identifying stocks with high price performance in recent history, up to 12-months. The MSCI USA Minimum Volatility Index aims to reflect the performance characteristics of a minimum variance strategy applied to the large and mid cap USA equity universe. The Russell 1000 Defensive Index measures the performance of the large-cap defensive segment of the US equity universe. It includes those Russell 1000 Index companies that are more stable and are less sensitive to economic cycles, credit cycles, and market volatility based on their stability variables. The Russell 3000 Index is a market-capitalization-weighted equity index maintained by the FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks which represent about 98% of all U.S incorporated equity securities The Russell 1000 Index measures the performance of the large-cap growth segment of the US equity universe.