Defaults in the high yield space still remain low, currently sitting at 1.9 percent, well below the 25-year average of 3.6 percent, according to J.P. Morgan Credit Research as of July 31.
It’s also important to remember that high yield has actually performed quite well in rising rate periods, as the chart below shows. It also tends to perform well in a positive growth environment, holding a 0.76 correlation with U.S. PMI, according to our analysis using data from Bloomberg. While we don’t expect a massive acceleration in growth, we also don’t foresee a recession. The environment we expect—slow, but positive growth—should actually be a favorable one for the asset class, maybe even relative to equities.
To be sure, the asset class is not without its risks. Energy and mining sectors represent 20 percent of the Barclays Capital High Yield Index, according to Bloomberg data as of July 31. Yet surprisingly, oil prices can explain 70 percent of the movement in spread levels of the entire index over the last year, our analysis shows.
High yield debt issuance has also continued to reach record levels, though we expect there will not be a rush to issue once the Fed moves on rates. In addition, high yield shares certain characteristics with stocks, so investors who are already heavily exposed to equities should consider a more modest allocation. In other words, allocation to high yield needs to be viewed in the context of an entire portfolio. Finally, as we see higher levels of stock market volatility, high yield volatility is likely to rise as well.
But here’s the bottom line: While there’s no denying the above risks, high yield’s positives still argue for some allocation in portfolios, particularly for investors with aggressive income objectives.
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.
Terry Simpson, CFA, is a Global Investment Strategist for BlackRock. He contributed to this article.