Shifting tide buoys US high yields

Since weathering a difficult first half in 2022, high yield has generated double-digit annualized returns for almost two and a half years, measured by the ICE BAML US High Yield Index. During the second half of 2022 and for much of 2023, the high yield spread was above historical averages. In 2024, the spread has been well below historical averages, even approaching historical lows, but the high yield market has continued to perform well. The tight credit spread is a risk that must be managed, but at the start of December, the yield at around 7.2% and dollar price below 96 cents continue to be attractive. Furthermore, the fundamentals are strong with a default rate that has been in steady decline down to 1.4%, compared to a long-term average above 3.6%.

However, the most important positive factor is the rising demand for the asset class. We believe there is a transitional shift underway as investors review their strategic fixed income allocations alongside the current opportunity set. As this shift occurs, blended multi-sector indices are gaining capital as investment managers drive funds to more credit-forward allocations that better align with these new, credit-intensive benchmarks (see Exhibit 1).

While higher yields have returned to many rates markets, lingering forward-looking uncertainty to the path of rates and supply/demand imbalances may continue. Meanwhile, maturity walls, refinancing risk, and cash flow burn in the form of fiscal deficits have become problems for some governments rather than solely corporate ones in today’s world. More importantly, given the recent uptick in correlation between stocks and bonds, some investors may doubt whether the risk-parity relationship has been restored, and instead markets may see higher structural correlations persist for some time. Collectively, these uncertainties are contributing to shifting investor demand for credit.

High yield inflows in 2024, even with low credit spreads, are comparable to 2020 when credit spreads were well above average for much of the year (see Exhibit 2). This dynamic suggests the current allocations are strategic rather than tactical. We believe this trend is in its early stages, and one that we expect will support high yield in 2025.