Yields Remain Attractive Even as Spreads Grind Tighter

Fallen angels (as represented by the ICE US Fallen Angel High Yield 10% Constrained Index, “H0CF”) slightly underperformed the broader high yield market (as represented by the ICE BofA US High Yield Index, “H0A0”) by 0.16% in July (1.26% vs 1.42%). Year-to-date, fallen angels are lagging by 0.73%, (6.19% vs 6.92%). This marks a significant shift from a year ago when fallen angels had a return of -12.35% for the first seven months of 2022. Underperformance was driven by a rally in lower quality bonds amid a rally in riskier credit, which have lower representation among fallen angels.

In July, fallen angel spreads tightened by 17bps, dipping below the 300 mark, a level that hadn’t been seen since March 2022 when spreads reached a low of 262bps. This tightening can be attributed to investors' growing confidence in better-than-expected earnings, resilient growth in the U.S., and a moderation in inflation. The U.S. Federal Reserve (Fed) raised rates by 0.25% in July, resulting a target rate of 5.25% to 5.50%, and government bond yields increased; however, this was offset by spread tightening.

In terms of fund flows, high yield corporates witnessed approximately $1 billion in inflows. , There was also notable movement along the yield curve, with over $9 billion flowing into intermediate duration and approximately $6 billion into long duration bonds.

Rates dominating spreads?

Historically, spreads have played a more prominent role in high yield investments, with a long-term average of 500 basis points – a very meaningful contributor to overall yield. However, the recent increase in rates (from 0% to 5.5%, based on Fed Funds) has driven overall yields to historically high levels (fallen angels yielding 7.25%, above the all-time average and median), making rates a more significant contributor to overall yields (and thus, returns) relative to history. As a percentage of yield, spreads are notably low, at 39% compared to the longer-term average of 64%.

Although overall yields are high, currently tighter than average spreads makes spread widening a potential concern if the U.S. economy experiences a slowdown in growth and a weakening credit environment. However, investor confidence in the concept of a soft landing has grown, supported by positive economic data highlighting a robust labor market and cooling inflation. This optimism is boosting interest in high carry/high yield trades. Despite relatively low spreads, the high overall yield helps mitigate potential losses from spread widening through a high level of carry. In addition, investors would generally expect interest rates to decline in a spread widening environment where they may flock to the safety of government bonds. In such an environment, and given the current valuations in high yield, we believe higher quality bonds may fare better than lower quality bonds. Currently, spreads between BB and Single-B rated bonds have compressed and are now below their 3-year, 5-year and 10-year respective averages. This suggests that in a deteriorating spread environment, lower quality bonds have a greater scope for underperformance.

We also note that high overall yields have resulted in an attractive payoff profile, as measured by the convexity of the fallen angle index. In other words, fallen angels have a higher potential for upside than downside, and to a greater degree than they have historically. This is due to the influence of rates on returns. The convexity of fallen angels is at its lowest point since July 2008, making a decrease in rates more impactful on price increases than an increase in rates on price decreases.

Overall, the prevailing factors influencing the market dynamics suggest that while rates are currently in the driver's seat for bond returns, the potential for spread widening cannot be disregarded. However, overall yield levels are undoubtedly attractive relative to history and provide significant downside protection against a spread widening scenario.

Fallen Angel Spread as % to Yield

Source: ICE Data Services, VanEck. OAS = Option-Adjusted Spread (OAS); YTW = Yield-to-Worst (YTW). Please see definition for these and other terms referenced herein in the disclosures and definitions portion of this blog. Past performance is no guarantee of future results. Index performance is not representative of fund performance. It is not possible to invest in an index.

Fallen Angels Overall Statistics: Fallen angels yields decreased in July by 10bps to 7.25 and broad HY yields by 20bps to 8.36, while the 10Y yield increased by 16bps to 3.97. Spreads for both tightened in July and the fallen angel market value declined as another issuer exited the index during the month.