Higher Rates And Wider Credit Spreads Make High-Yield Bonds Look More Appealing To Us Over The Long Term
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Key Points
• Valuations reset across most assets in 2022, leading to a rise in expectations for longterm returns for many risky assets, including high-yield bonds and equities.
• We view valuations as a better long-term asset allocation signal than a justification for short-term portfolio changes.
• Despite improved long-term return expectations, our cautious near-term macro-outlook— with significant recession risk—leads to a less favorable view of risky assets, such as high-yield bonds and equities, over the next several quarters.
• Putting it all together, the improvement in valuations currently leaves us moderately bearish on risky assets given our cautious cyclical outlook.
Introduction
Franklin Templeton Investment Solutions (FTIS) is optimistic about the performance potential for risky assets over the long term, which we consider to be a full business cycle, or about 10 years. However, our short-term preference (over the next 12 months) for risk assets is more cautious, based on our macro outlook. Some might notice these opposing viewpoints and wonder what signals would make an investment manager bearish in the short-term and bullish over the long-term, and how they balance this tension in a portfolio. Here, we attempt to provide the rationale behind these opposing views. While generally applicable to all risky assets, we will focus specifically on high-yield bonds and equities.
Long-term return expectations have improved
Our long-term return expectations have risen across every asset class, due largely to the market declines in 2022, which have reset valuations (Exhibit 1 on the next page). In equities, lower price-to-earnings (P/E) multiples (and thus higher earnings yield) now mean that valuations are a tailwind over the foreseeable future, rather than a headwind. In fixed income, interest rates have risen across the yield curve. Higher rates and wider credit spreads make high-yield bonds look more appealing to us over the long term.
Historically, valuations have been helpful indicators of long-term returns. As an asset class gets cheaper (i.e., yields increase), generally the long-term return expectations increase. However, valuations are much less effective at predicting shorter, one-year returns (Exhibit 2 on the next page).
Focusing on the long term
We believe it’s hard to argue against the long-term case of high-yield bonds and equities, assuming they fit an investor’s risk parameters and investment horizon. Historically, high-yield bonds have produced a total return somewhere in between US stocks and investment-grade corporate bonds. And they have achieved these returns with less volatility than equities, resulting in what we believe to be strong risk-adjusted returns (see Exhibit 3).
High-yield issuers usually have less equity and/or more leverage on their balance sheets, which raises their default risk and leads to a higher credit spread when compared with their investment-grade counterparts. The higher credit spread leads high-yield bond returns to move more in lockstep with the perceived financial strength of their issuers. Thus, they usually respond to the strength of the economy (similar to stocks) more so than changes in interest rates, which tend to impact investment-grade corporate bonds to a greater degree. Put simply, high-yield bonds have more exposure to the economic growth factor, while investment-grade bonds have more exposure to the interest-rate factor. Investors are compensated for this extra credit risk with excess returns—at least when times are good, and the default rates are low.
What about when times are bad? Of course, like equities, high-yield bonds are not impervious to downturns. But so far, we have never observed two straight calendar years of negative returns in the high-yield asset class (see Exhibit 4). With a streak like that, should investors consider high yield?
Our view (short-term vs. long-term)
Our near-term macro outlook for 2023 remains cautious. While inflation may have peaked, we believe it will remain above the US Federal Reserve’s (Fed’s) target levels of 2% for some time. The Fed has repeated that it is unconditional in its fight against inflation, with the hope that it can lower job openings (weaken wage inflation) without materially affecting
employment. We think this will be difficult to achieve. We also believe that growth and employment need to weaken to fully normalize inflation. FTIS’ odds for a US recession over the upcoming year remain high at 65%.
The implications of this viewpoint for asset allocation are straightforward. Risky assets, such as equities and high yield, have performed poorly heading into recessions (see Exhibit 5).
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During recessions, the high-yield risk premium, or spread over Treasuries, typically spikes up to compensate for anticipated higher defaults. At its peak, the default rate has reached more than 10% in a recession and spreads often widened past 7%. We do not think high-yield bonds are currently pricing in a recession from a spread valuation perspective (see Exhibit 6). In other words, the market, in our view, is not pricing in the much tighter financial conditions and weaker financial performance for issuers that often comes with a market downturn and can lead to an increase in defaults.
A volatile year ahead
At the opening of 2022, we believed the Fed was walking a tightrope heading into the year.2 Unfortunately, it is still on the same tightrope, in our view, as the central bank tries to engineer a soft landing in 2023. The Fed will likely try to pause its interest-rate hikes at some point in 2023, fearful of driving the US economy into recession. The market is pricing in Fed rate cuts in 2023 due to growth worries. We find this scenario unlikely, and think the Fed is likely to keep rates restrictive throughout 2023. As always, what ultimately happens will depend on a number of variables, many outside the Fed’s control, including the US economy’s sensitivity to higher interest rates, and how geopolitical developments evolve.
The performance of risky assets will depend on these variables, among others. Returns at year end don’t reflect the volatility experienced along the way. Prices will likely be volatile until the market has an unobstructed view of clear skies ahead—and that will likely begin with the Fed’s policy actions.
This is why we believe that nimble, active management is important, especially in times like these. Our own viewpoint will change as our cyclical outlook changes.
Conclusion
Improved valuations have increased the long-term expected return outlook for multi-asset portfolios in general. However, in the near term, we weigh our cyclical outlook more heavily, which leaves us defensively positioned given our view of significant US recession risk. This combination of improved valuations and an uncertain near-term view leaves us moderately bearish toward risky assets, such as high yield and equities.
Source: Making sense of different signals | Franklin Templeton
