The chart
The difference between the median (a more accurate indicator for investors) and headline index spread is at a 20-year high.
Source: ICE BofA US High-Yield Index. 23 February 2024. Peak spreads not shown in chart: 1959bps (headline); 1637bps (median). Indices are shown for illustrative purposes only, are unmanaged and do not take into account market conditions or the costs associated with investing. Further, the manager’s strategy may deploy investment techniques and instruments not used to generate Index performance. For this reason, the performance of the manager and the Indices are not directly comparable.
The context
Attractive yields are enticing investors back to credit markets. Certain markets offer attractive compensation for risk, but in more traditional areas a combination of strong inflows and limited net issuance has driven spreads to historically tight levels. Furthermore, headline index spreads for such markets often paint a misleading picture, effectively overstating how much investors are likely to earn. The US high-yield market is a key example.
Investors who ‘buy the market’ will not necessarily earn the headline spread of the index. As a weighted average, this headline spread assumes that all index constituents – including very distressed bonds - will be redeemed at par. In reality, some of these distressed issuers will likely default, and thus a portion of that spread is unlikely to ever be realised (this is often referred to as the ‘phantom’ spread).
In addition, there is currently a high level of dispersion (‘fat-tails’) in the high-yield market - something Picture this has touched on before. This reflects higher-quality (BB rated) segments receiving far more investor interest than riskier (CCC rated) segments.
These two dynamics have resulted in the median index spread – a more accurate representation of the typical spread in the market – being significantly lower than the headline index spread. As shown in the chart, the median spread is now at its tightest since 2007, and around 30% (100bps) tighter than the headline index spread. The difference between the two is the largest it has been in 20 years.
The conclusion
Given how expensive the asset class has become – the full extent of which is not captured by the headline index spread – we believe that a static, index-level allocation to US high-yield is unattractive. Reflecting this view, we have reduced the US high-yield allocation within our Multi-Asset Credit strategies to an all-time low. Looking across the wider global credit market opportunity set, we are finding risk-adjusted value in segments such as structured credit, bank loans, and subordinated financial bonds. Investors should broaden their horizons to seek the best opportunities on offer in credit markets today.
