Until the last few months, U.S. high-yield bonds had been one of the best-performing asset classes in the global fixed income markets. Since 2009, investors have generally been rewarded for assuming ever-greater amounts of credit and interest rate risk.1 However, there has recently been a marked divergence between U.S. equity and high-yield bonds. Given the historically strong correlation between these two markets, we believe that high-yield credit may represent an attractive opportunity for investors seeking to benefit from stronger U.S. growth.
Over the last year, U.S. equities rallied, and credit spread generally tightened. However, in recent months, this winning formula has started to diverge. Concerns about global growth, potential changes in monetary policy and uncertainty from geopolitical risk weighed on investor sentiment. In response, equities fell, and credit spreads widened. As we show in the chart below, even though stocks have since rebounded, creating fresh all-time highs, U.S. high-yield credit spreads have failed to recover. In fact, credit spreads are actually significantly wider than they were to start the year.
High-Yield Credit vs. S&P 500 Index, 10/31/13–11/07/14
For definitions of terms and indexes in the chart, please visit our glossary.
Default Rates vs. Flows
To understand which market is potentially under- or overvalued, it’s important to understand what might be driving this divergence. Historically, credit spreads and equities have generally exhibited a fairly consistent correlation, given that both benefit from positive economic momentum. With increasing corporate earnings, stock prices have risen. In an improving economy, risky borrowers generally pose a lower risk of risk of default due to strengthening fundamentals.2 Examining default risk more closely, over the last 12 months, Moody’s reported that the average issuer default rate decreased to 1.7%. This compares to the 2.8% rate they reported at this time last year.3 With the economy continuing to perform, corporate fundamentals seem to be broadly supportive of strengthening credit conditions.