Insights
High Yield Outlook: Elevated Yields Endure into 2025
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Navigating The Curve
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February 07, 2025
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High Yield Outlook: Elevated Yields Endure into 2025
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February 07, 2025
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High Yield Outlook: Elevated Yields Endure into 2025
High Yield Outlook: Elevated Yields Endure into 2025 |
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| 1 | Income investors are at an interesting juncture, confronting elevated base interest rates alongside and an uncertain policy environment. |
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| 2 | High yield remains an attractive investment option against this backdrop, given the sector’s solid credit fundamentals, potential for relatively attractive income and return enhancement. |
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| 3 | In particular, starting yields, which we believe are at attractive levels today, have historically been a strong indicator of future return potential in high yield bond markets. |
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| 4 | We see compelling opportunities across high yield, but expectations for above average volatility places an added emphasis on the need for active management. |
Charting the course in 2025
Monetary easing by the world’s major central banks is now in progress, as the worst of the post-pandemic inflation surge now appears contained. The initiation of rate cuts received a warm welcome from the market in 2024, as did the Republican Party’s sweep at the U.S. elections, which underpinned a confident outlook for 2025.
However, the recently inaugurated U.S. administration’s policy proposals raise key questions about future inflation, interest rates and global growth. In short, there’s more policy uncertainty, which is already shaping market dynamics. For instance, traders were quick to reprice post-election rate forecasts (i.e., slower easing by the Fed, faster easing by the ECB) and reacted in similar fashion following the Fed’s “hawkish cut” at its December meeting. Policy rates are, nonetheless, still projected to continue on a downward path in most major markets over 2025.
As central banks transition away from higher base rates, investors may be evaluating new allocations to increase or preserve the income in their portfolio while elevated yields continue to endure. To this end, whether one is interested in U.S., European or global exposure, high yield bonds have qualities that we believe are well-suited to meet a broad range of investor needs.
The power of starting yields
The “high yield” label points to one of the sector’s most attractive features: Higher coupon payments than most other areas of fixed income. Yield-to-worst figures from the end of December attest to the sector’s income potential. At the index level, U.S. high yield registered a 7.5% yield against 5.33% for U.S. investment grade bonds, while European high yield had a 5.7% yield compared to 3.18% for European investment grade.1
The sector’s yield appeal does not stop at comparisons to other bond markets, as current yields are also compelling relative to the sector’s own yields historically. Importantly, that could matter for timing an entry or planning when to add exposure to the asset class. As illustrated in Display 1, investors allocating at higher starting yields, such as we see today, have gone on to earn higher long-term total returns.
The data show that investors who allocated at yield-to-worst levels in the 5-7% range to either U.S. or European high yield, typically earned annualized total returns of roughly 5% or more on a five-year investment basis.
Spreads currently reflect a healthier market
Beyond the yield opportunity, investors will understandably want to take a view on current valuations and potential upside. Admittedly, at 310 basis points (bps) and 340bps at the close of last year, headline spreads for U.S. and European high yield appear relatively tight against long-term averages – a trend that’s consistent across credit, including investment grade bonds.
What reasons do we see that can justify tight credit spreads?
- Leverage levels in the U.S. and Europe have not shown any broad-based signs of weakness
- Interest cover remains healthy at ratios above historical averages
- Default rates and distress ratios sit below historical averages
- Higher rated bonds now comprise a growing proportion of U.S. and European indexes;
- And, lastly, investors enjoy stronger credit protections than in past years thanks to higher levels of secured issuance.
Like fundamentals, the picture for technicals also appears strong. On the supply side, we expect increased capital raising by corporates to support issuance, with demand for M&A financing playing a key role. Dealmaking is heating up in the U.S. and Europe, with forecasts for transactions ticking higher for 2025 – particularly, for the U.S. market, where robust confidence, strong corporate balance sheets and high share prices are being met with prospects for deregulation, greater clarity on tax policy, moderately strong growth and lower interest rates. This should sustain healthy new issuance, bolstering the opportunity set with a wider diversity of investible securities.
On balance, we believe the more supportive backdrop may see fewer catalysts for significant spread narrowing, with any widening potentially offset by strong buyer demand.
Potential risks and opportunities?
Healthy credit metrics alone do not indicate an absence of risk. Despite tighter spreads at the headline level, dispersion is elevated in both the U.S. and Europe, as investors increasingly discriminate between outperformers and those that fail to deliver. Measured as the proportion of total constituents trading at +/- 100 basis points of the overall index level, U.S. and European high yield dispersion rose to 64% and 71% by December 2024, respectively. That compares to less than 50% during 2021.2
In 2025, policy uncertainty will likely be more formative for the risk landscape. While the U.S. administration is in the global spotlight in this regard, protectionism, stricter immigration controls and industrial policy are talking points in other capitols too. As such, government policy should be monitored closely, given its potential to reverberate across borders as well as between and within sectors.
Agile, risk-aware approach warranted
As a result, a discerning approach to security selection is imperative, not only to mitigate risk but to enable alpha capture. Passive high yield bond funds, which are designed to track a specific market index, are structurally incapable of such discernment. Even active managers who lack adequate research capabilities, long sector experience and proven investment strategies may find themselves at a disadvantage.
Simply put, high yield is a resource intensive and complex bond sector, requiring analytical heft and deep experience trading through multiple cycles. Able managers should be adept at identifying idiosyncratic credit risk, while exploiting market inefficiencies and price discrepancies across regions, the credit spectrum and between and within individual sectors.
Fund managers that meet these criteria will, in our view, be better equipped to capitalize on high yield’s ample and differentiated sources of alpha.
Bottom line
Whether seeking U.S., European of global exposure, we believe that high yield bonds are well suited to help investors meet their income and total returns goals in 2025 and beyond. The sector’s high starting yields offer the ability to not only clip attractive coupons but to earn potentially compelling long-term total returns. High yield’s strong fundamentals and supportive technicals backdrop should act as stabilizers in a market that is more likely to be policy driven. However, with spreads tight on a historic basis and dispersion rising, maintaining a highly judicious approach to credit selection will be key to investment success.
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Dónal Kinsella
Institutional Portfolio Manager, High Yield Bonds, Morgan Stanley
Investment Management |