The graph that highlights the opportunity in high yield

The main way in which the corporate bond market is divided is into ‘investment grade’ and ‘high yield’. Over time, many institutions and the rules that govern them have used this distinction to guide where they invest.

For instance, many risk-averse institutions are only allowed to own investment grade bonds and cannot buy any security rated below that level. Further, the capital charges banks are subject to jump sharply when dealing with high yield¹.

This seems sensible, as non-investment grade bonds are of course more likely to default. But is the difference between the two really that clear cut? We would argue that it isn’t and that this presents opportunities.

The graph below shows the 12-month historic default rates for investment grade and non-investment grade bonds between 1981 and 2021. As you can see, there is quite the jump in the percentage of defaults from the lowest-rated investment grade security (BBB) to the highest-rated non-investment grade one (BB): from 0.15% for the former to 0.6% for the latter – a quadrupling of default risk².

Yet looking at it the other way, it means that on average 99.4% of BB-rated bonds met their repayments in any giving year.

Default risk

While many organisations’ cut-off point is between BBB and BB, the data shows there is a far higher discrepancy between the two highest ratings of non-investment grade bonds: BB and B.

One- year global default rate, S&P weighted long-term average, 1981-2021

On average, 3.18% of B-rated bonds defaulted per year between 1981 and 2021, more than a five-fold increase over BB-rated bonds³.

Yet this gap is dwarfed by the difference between B-rated bonds and the rest of the high-yield market that sits below them. On average, more than a quarter (26.55%) of bonds rated CCC or below defaulted in a given year – an increase of 2,337bps, or 735%⁴.

Therefore, we would argue that when evaluating how much credit risk to take, the most consequential decisions come from how you allocate within the high yield market, rather than just being in or out of the market itself.

CCC-rated bonds get a lot of attention in high yield – and for good reason, as they tend to be the most dramatic area of the asset class – but equating them with the market risks missing the wider opportunity in bonds which do overwhelmingly boring things such as provide us with attractive yields before being repaid.

Not telling the whole story

The graph above doesn’t tell the whole story. Some investors might look at it and think that about a third of the market is at high risk of default, worrying that while B-rated debt has been relatively safe, bonds in this category could easily move down a grade.

In reality, just 8.5% of the high-yield market is in debt rated CCC or below, a figure that has fallen from between 17 and 18% in the run-up to the financial crisis⁵. While the high-yield market has grown since then, most of this growth has been in BB debt – even the proportion of B-rated bonds has fallen⁶.

Highest quality part of the market - BBs - have significantly increased their share of the market

This direction of travel is important as although spreads are trading at about their 20-year averages⁷, the growth in the higher-quality end of the market means investors are taking a much lower level of risk for this so-called ‘average’ amount of additional spread. It is our belief that at yields of just under 9%⁸, the high-yield market more than compensates them for the associated risk.

Bonds are back

There are other ways in which the risk in the high-yield market is being overestimated. One of the major concerns at the beginning of 2023 was that the companies that had been issuing lots of debt would have to refinance at higher interest rates.

But what we have seen instead is a trend for companies to issue less debt or buy back more of their bonds⁹. Why? It is worth remembering that many of the companies issuing debt when interest rates were close to zero were simply responding to the environment and doing so by choice: borrowing to fund share buybacks or an M&A programme made a lot of sense when you could do so at 1%.

Now the mathematics are changing, companies are reversing course and reducing their debt levels in response. Of course, some companies will find this more difficult than others, and an active approach to stock selection is needed to sort the strong from the weak.

Quality in high yield

A good example of this is Kraft Heinz. Despite the pedigree of its brands – many of us grew up on its baked beans and ketchup – and its backers – Warren Buffett’s Berkshire Hathaway owns about a third of the company¹⁰ – it was downgraded from investment grade to high yield in 2020¹¹.

Kraft Heinz wasn’t downgraded because it ran into trouble, but because it decided to take on more debt while money was cheap. And surprise, surprise, now that rates have gone up, it simply repaid much of this and has regained its investment grade rating¹².

There are some areas of the high-yield market where we think concerns are probably warranted, especially those that are vulnerable to the rise in interest rates. But we don’t like to take a blanket approach – as the post-QE era develops, we are seeing a greater disparity of outcomes at the sector and individual security level.

For us, it isn’t necessarily about the label of investment grade or high yield – whether something is rated BBB, BB or B, the important thing is to be selective.