Viewpoint  |  January 16, 2024

US High Yield 2024 Outlook

2023 was a strong year for all asset classes, including US high yield, although it is unlikely that 2024 will be a repeat. The performance run of last November and December brought forward 2024’s return potential, and valuations moved to relatively full status across both equities and fixed income. Much of this rally was driven by the market’s belief that the US Federal Reserve is done hiking (with six cuts coming this year) while sticking a soft landing.  Navigating 2024 will now be more challenging than it was at the end of October. 

Looking ahead, we see several risks and opportunities for the asset class in the coming year.

Opportunities

 MACRO

• The economy is still moving forward, and inflation is abating (6-month annualized core inflation is 1.9%).¹The Fed has an opening to slowly cut rates without stoking inflation or a recession. A ‘Goldilocks’ scenario (not too hot, not too cold) would be positive for high yield.
• The US high yield market is approximately 90% exposed to the US and Canada, the strongest economic block.²

MICRO

• US high yield continues to maintain a high-quality bias with limited CCC issuance.  High risk paper has moved into other asset classes like leveraged loans and private debt.
• The YTW of 7.96%² offers investors a yield that is 50-150 bps greater than the 5, 10, 15, and 20-year averages. 
• Spreads are inside their historical averages but still 50 bps above the post-GFC low and 110 bps above the post-2000 low.  Spreads can compress in a soft landing, low volatility (VIX/MOVE) scenario.
• The average high yield coupon is increasing. During most normal periods coupon income generates 50-100% of an investor’s total return.²
• Default candidates are well known with bond prices well below par. Realized credit losses from defaults will be minimized because of this and should not damage returns materially.
• The DTW of 3.65 years is relatively short and less likely to be impacted by rate volatility compared to higher quality asset classes.  Short duration high yield has approximately two years less duration, further mitigating rate volatility.
• Reallocation to high yield after two years of investors being overweight quality and long duration. 
• Money market assets looking to generate higher returns as the Fed cuts rates.

Risks

MACRO

• A Fed misstep. High inflation or a recession would be challenging for high yield valuations.
• A consumer pullback around a weak jobs outlook.
• Expansion of current geopolitical hotspots and conflicts. 
• Uncertainty about the 2024 election.  This is a short-term phenomenon, although fears around a January 6, 2021, redo could linger depending on the outcome of the election.

MICRO

• Poor technical factors due to hedging costs coupled with fewer net rising stars.
• Investor malaise after the strong performance end to 2023.

Our Strategy

Sector Exposures

Major sector issues seem focused on telecommunications, broadcasting, and healthcare.  Most other sectors either have decent trends or have already experienced contractions and are reverting to norm. Maintain diversification, including energy.

Rating Posture

Maintain exposure to BBs and Bs while minimizing CCCs due to market access concerns.  A balanced approach to BB/B exposure is acceptable given the economic outlook.

Duration Posture

Underweight-to-neutral seems optimal after the fourth-quarter rate rally given the higher-for-longer mantra of the Fed.  Move to neutral-plus on a major repricing of rates to a higher level.

Yield / Spread

Slightly greater than benchmark given continued economic growth.

USD/EUR

Move toward neutral mix from overweight EUR via organic cash flow given the convergence of net yields after hedging.

Bonds/Loans

Maintain exposure to loans given the carry advantage and limited volatility relative to high yield bonds. Follow the economic data and Fed direction and look to reduce loans if the speed of Fed cuts accelerates.

PUTTING IT INTO PERSPECTIVE

It is difficult to predict where markets will move in any given year, but we would like to provide some data about how high yield performs after negative periods like 2022.

Past performance is not a reliable indicator of current or future results.

Source: ICE Data Platform, ICE BofA US High Yield Index, (J0A0), as of 31st December 2023. For illustrative purposes only.  Index performance is for illustrative purposes only. You cannot invest directly in the index.

Several items stand out from this data. 

1.6 of 7 negative return years since 1990 saw multiple years of positive returns before another setback.

2.The recoveries easily covered the drawdowns over the recovery, even after 2008.

3.The annual rate of return typically ebbs as the length of recovery increases.

CONCLUSION

Looking at the asset class’s historical performance leads us to believe that high yield is poised to produce a positive return in 2024, albeit not as robust as that experienced in 2023.  We believe that the economy is not rolling over and that a recession is likely to be at least six months away. Lastly, Treasury volatility is expected to remain elevated until such time as the market is convinced that the Fed is cutting rates consistently and that the economy is not cratering.

Given these assumptions, we believe that exposure to high yield is warranted and investors should aggressively deploy capital during dips associated with either rate increases or risk-off periods.  Such a strategy allows for participation in the asset class if the economy continues to move forward while locking in higher yields and potential capital gains around selloffs. This cycle may prove to be elongated given some of the structural changes due to Covid and yields back to pre-GFC levels due to a higher-for-longer Fed. We are back to being the high yield asset class.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of January 2024 and may change without notice.

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