September 2022 / VIDEO
Outlook May Favor High Yield Bonds Over Equities
High yield bonds could offer a yield advantage relative to equities.
- An unfavorable 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 thenear term
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.
Stronger Fundamentals Lower Potential Default Risk
(Fig. 2) Interest coverage ratios show that company earnings for high yield issuers farexceed their ongoing interest expense
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.
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