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October 2022 / ASSET ALLOCATION VIEWPOINT

Outlook May Favour High Yield Bonds Over Equities

High yield bonds could offer a yield advantage relative to equities

  • An unfavourable macroeconomic backdrop is weighing on the near-term global economic outlook and is a headwind for equity markets.
  • In our view, high yield bond fundamentals are strong, and they could offer investors a compelling yield advantage relative to equities. 

The confluence of several factors—including tightening monetary and fiscal policies, geopolitical turmoil, and stubbornly high inflation—has created an environment in which the potential risks for equities outweigh the potential rewards in the near to medium term. 

For investors seeking alternatives, we believe that high yield bonds currently may offer a compelling yield advantage relative to equities. In particular, a comparison against the forward equity earnings yield, which accounts for a company’s entire earnings and not just the portion paid out in dividends, shows a significant yield advantage for global high yield (Figure 1). Further, while equity earnings may be revised downward if economic growth weakens, a potential added advantage for high yield bond investors is that cash flows are unlikely to be affected unless a company defaults. 

High Yield Advantage Over Equities

(Fig. 1) High yield bonds could offer a more attractive risk/reward trade-off in the near term

High Yield Advantage Over Equities

Past performance is not a reliable indicator of future performance.
Sources: Bloomberg Index Services Limited and MSCI. T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved. See Additional Disclosures.
*Yield to worst is a measure of the lowest possible yield that can be received on a bond with an early retirement provision.
† Forward earnings yield is calculated by dividing the expected earnings per share (EPS) in the next twelve months by the current share price.
‡ Forward dividend yield is the percentage of a company’s share price that is expected to be paid out in dividends over the next year.

Although we recognize that credit risk is a valid concern, credit quality in the high yield universe has steadily improved, on average, since the end of the 2008–2009 global financial crisis. Over the past 15 years, the share of high yield bond issuers in the Credit Suisse High Yield Index rated higher than single B—levels typically deemed less susceptible to default risk—has increased from 37% to 59%.  

High yield sector fundamentals are also generally stronger since 2008, with corporate balance sheets holding more cash and less leverage, as illustrated by interest coverage ratios (Figure 2). While earnings could decline in a recessionary scenario, we believe healthy balance sheets could help limit widespread default risk. 

In our view, financial markets face a challenging economic environment, with an increasing likelihood of a global recession within the next year. While our Asset Allocation Committee remains cautious and is maintaining a notable underweight allocation to equities, we believe that high yield bonds are supported by strong sector fundamentals and could offer relatively attractive yields. 

Stronger Fundamentals Lower Potential Default Risk

(Fig. 2) Interest coverage ratios show that company earnings for high yield issuers far exceed their ongoing interest expense

Stronger Fundamentals Lower Potential Default Risk

Past performance is not a reliable indicator of future performance.
Sources: Based on J.P Morgan North America Credit Research. Not from an Index.
EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization.
CAPEX = Capital Expenditures.

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

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