Whether looking at the US, UK or further afield, there is much concern and confusion regarding economies and the timing of expected interest rate reductions. While inflation data suggests these changes could come sooner rather than later, economic figures can often suggest otherwise. However, it is widely expected that interest rates will fall in 2024 and into 2025, which has prompted private and institutional investors to look towards the corporate bond market.




At this moment in time, the likes of Bloomberg are carrying news which suggests that the US is looking at recession odds of between 40% and 50%. The consensus indicates that the US will avoid a recession, as will the UK, which puts an interesting spin on the fixed-interest market, particularly high-yield corporate bonds. To understand what is happening in the fixed-interest market, we need to examine how the dynamics and structure of the corporate bond market, particularly high-yield bonds, have changed since the pandemic.




As with the global population, the pandemic created an environment that can best be described as "survival of the fittest" in relation to corporate bonds. While this is a rather brutal summary, it perfectly illustrates how the high-yield corporate bond market has changed in recent years.


Currently, around 50% of the high-yield bond market is made up of BB-rated bonds. This is a significant increase from just one-third around a decade ago, highlighting that the weaker have fallen by the wayside. To further strengthen that scenario, the number of CCC-rated bonds in the junk market is now at a decade's low. So, we have had a shakeout of the weaker corporate bonds and a strengthening of those that managed to survive the pandemic.


Another factor to consider is the absence of high-yield corporate bond issues over the last few years, which is only now beginning to change. This is prompting growing demand in the US corporate bond market.




If you look at high-yield bonds, we know that historically, with a 40% to 50% chance of a recession, the yield premium should be between 483 basis points and 1726 basis points. This is a wide band, but if we look at the median spread for this scenario, historically, it should be 795 basis points. Currently, the yield spread is just 347 basis points, which is extremely low and suggests limited value. But is this the case?


Investment-grade bonds


Such is the strength of opinion that US interest rates will fall this year; investment-grade bond yields have fallen to within a hair's breadth of Treasuries. In reality, this means that investment-grade bonds are banking on interest rate reductions to deliver outperformance. While unlikely, if the US economic situation changed dramatically, those who bought into the idea of rate reductions and invested in investment-grade bonds would be exposed. What about high-yield bonds?


High yield bonds


The situation with high-yield bonds is very different to investment-grade bonds, where they still offer a significant yield premium. As we touched on above, the pandemic prompted a shakeout of the high-yield corporate bond market, leaving a higher percentage of BBB-related bonds. So, while the yield premium may be towards the lower end of historical figures, we aren't comparing like-for-like with the improvement in high-yield corporate bond quality.


Recent data also shows that the average price of short-dated high-yield bonds is around $0.92 on the dollar, creating a return on the pull to redemption together with the yield premium.




Many analysts now believe there is greater value in the short term high-yield corporate bond market, with a yield premium, reduced risk and pull to redemption compared to investment-grade bonds. The higher-grade bonds are more exposed to any interest rate shocks, such as a delay in the reduction of rates, whereas those holding high-yield bonds are also enjoying a pull to redemption. Ultimately, the short, medium and long-term direction of bonds, investment-grade or high-yield bonds, will be heavily influenced by base rate movements. To what extent will dictate short-term returns.

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