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Back to the future of fixed income, part 2: The search for more income

As investors rethink fixed income, understanding the state of high yield is imperative in addressing today’s income challenge and to successfully navigating the future of fixed income.
March 2021

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Cartoon depicting how investing in high yield appears to look easier than doing so with government yields

Negative yields: A disruption in the space-time continuum

In our own recent time travel, we recall the shock and confusion of only a few years ago when negative yielding debt became a topic of conversation. Still a mind-bending concept, the collective crushing of global yields in the pandemic brought negative yielding debt to record levels. The expansive monetary policy support since has kept yields from rebounding to the same degree as risk assets have. The result is that nearly $18 trillion of debt was trading with negative yields as of the end of 2020.

With that debt representing over a quarter of the global aggregate index, it takes little imagination to see how desperate the world is for income generating assets.

Market value of negative yielding global debt

Market value of negative yielding global debt from December 2009 to December 2020

Source: Bloomberg Barclays.

Where to find income in the future? High yield as an income source

Even with the significant rebound of non-governmental fixed income and risk assets more broadly since March 2020, high yield presents a significant yield pick-up versus other traditional fixed income.

Of note, this income comes with a lower duration profile in contrast to both traditional higher quality assets as well as other higher yielding segments. This attractive income to interest rate sensitivity has long been true; recent changes in the market have only added to the attractiveness of this profile.

Yield to maturity by market sector (as of February 28, 2021)

Yield to maturity by market sector as of Jan 31 2021

Source: Bloomberg Barclays, ICE BofA ML, BMO Fixed Income.

The effects of a dystopian year – did Biff steal the almanac?

One barometer of just how extreme the market volatility was in 2020 was that the high yield index traded into distressed territory (i.e. above 1,000 basis points of spread.)

U.S. high yield corporate spreads (weekly)

Weekly US high yield corporate spreads from December 2014 to November 2020

Source: Bloomberg Barclays.

Distress ratios have improved since ending at 31% at the end of March 2020, declining to under 4% by the end of the year. While the issuers with distressed level spreads are concentrated in sectors such as energy, transportation and media, it is noteworthy that the energy sector had a lower distressed ratio at the end of 2020 than at the start of it.

As is typical in economic recessions (though the pandemic recession was not a typical one), corporate defaults accelerated as did credit downgrades. Also as is often the case, market action front-ran corporate fundamentals, selling off prior to the stress and rallying prior to fundamentals recovering.

Global defaults trended higher in the fourth quarter of 2020, ending the year at a rate of 6.6% for the trailing twelve months. Moody’s projects defaults will peak at 7.3% in March 2021, materially below historical levels in the 10-12% observed during past periods of distress and improve solidly to end the year at 4.7%.

High yield by credit quality

High yield by credit quality from December 1996 to December 2020

Source: Bloomberg Barclays.

Paradoxically, in 2020, one of the largest systematic and global shocks on record, the percentage of BB in the US high yield index increased from 52% at the end of 2019 to 58% at the end of 2020. The pattern in 2020 was not the exception, but rather an acceleration of a long developing trend. Over the past two decades the percentage of BB, the highest quality echelon within high yield, has doubled from 29% to 58%.  This shift is not just academic, but has real implications for default and recovery assumptions for investors going forward.

While BB default rates are modestly above that of investment grade historically, the likelihood of default rises exponentially as ratings declines.  The meaningful shift higher in quality composition of the benchmark over time suggests a real shift lower in default expectations for high yield investors.

Median default rate by credit quality (1994-2020)

Chart showing Median default rate by credit quality 1994-2020

Yield-to-worst data as of 12/31/2020 for relevant BofA Merrill Lynch Corporate Indices. Default rate uses Moody’s data

Altering the past?

Ironically, one of the ways in which high yield quality increased was because investment grade quality decreased.  ‘Fallen Angels’, bonds originally issued as investment grade, but downgraded to high yield, eclipsed $180 billion in 2020, more than double the previous record of $70 billion set in 2016.  As a percentage of the HY market, fallen angels have doubled since the end of 2019 from 8% of the index to over 16% by the end of 2020.

This impact is visible not only in quality ratings, but also in high yield fundamentals. Corporate leverage rose materially early in 2020 as would be expected with the COVID impact to earnings and subsequently with the Fed induced liquidity incentivizing issuance. Noteworthy though amidst the increase in leverage – a trend we expect will improve in the coming year as earnings and the economy rebound – is the improvement in corporate liquidity, with high yield issuers having over 75% higher cash balances since the end of 2019.

With the world optimistic regarding COVID, but not out of the woods, continued downgrades into high yield are likely.  Thus, further downgrades could continue the trend to higher quality in high yield, with an expansion of the opportunity set in high yield.

Altering the future?

It is not downgrades to high yield alone driving this trend.  While the market value of BBs outstanding has increased by 32% over the past 5 years, B and CCC segments have declined by -8% and -16% over that time period.  Existing bonds continue to mature or in many cases are tendered for, while new issuance has shifted to higher quality issuers in recent years.

Issuance by ratings sector

Chart showing Yield to maturity by market sector as of Jan 31 2021

The recent trend of issuance has been towards higher quality issuers. Source: BofA ML.

The quality of issuance is different in character than the historical composition and volume is different in scale. Issuance in 2020 set a record for the high yield market, exceeding $400 billion in issuance in the U.S., almost 45% above the prior record. Net issuance, the issuance of new bonds less those that mature or are tendered, is particularly noteworthy as bonds were called or tendered at a record pace in 2020. Net issuance of nearly $170 billion broke the prior annual record by almost 80%.

2020: A record for gross and net high yield issuance

2020 was a record for gross and net high yield issuance

Source: BofA ML, BMO Fixed Income

Would you have guessed this? Even if you knew the future?

High yield is generally viewed as delivering a risk and return profile between that of equities and investment grade fixed income — a profile we would continue to anticipate looking forward. However, it is interesting to note that over the first two decades of the millennium, even high quality high yield has outperformed equities (7.07% vs. 6.96%) with half the volatility 8.3% vs. 15.2%.

High quality high yield has outperformed equities this millenium

High quality high yield has outperformed equities this millenium

Source: S&P, ICE BofA.

It could be tempting to view this performance as largely about the significant decline in rates seen during this period. However, it is coupons and interest income that have driven the returns. In fact, for the past decade, income has contributed 100% of return versus a contribution of 0% from price appreciation. For the past two decades, this pattern is more stark with a contribution of -0.94% annualized from price return and income contributing 7.66%, more than the full return of 6.72%.

High yield corporate price return versus income return (2011-2020)

High quality high yield has outperformed equities this millenium

Source: Bloomberg and BMO Global Asset Management as of 12/31/2020. High yield corporates are represented by the ICE BofA U.S. Corporate BB — B Index. Investments cannot be made in an index. Past performance is not a guarantee of future results.

Are time travel or benchmarks real?

The record issuance and volume of calls and tenders have created a high degree of turnover in benchmarks, both in absolute terms and relative to other fixed income benchmarks. At the same time, high yield has notably wider bid/ask spreads and generally lower liquidity than investment grade counterparts (though more liquidity than many higher yielding alternatives). The result is that high yield benchmarks are, depending on one’s perspective, either notoriously difficult to match or simply not representative of the investable universe.

Acknowledging at least one facet of this difficulty, the ICE family of indices has recently moved to include transaction costs in their benchmarking, noting that ”over the last 15 years, the impact of transaction costs on the U.S. High Yield Index (H0A0), including all additions and additional amounts, is an annualized -0.40%.”

Active and passive strategies alike have struggled to replicate high yield returns. Some of the factors driving this difficulty remain unaddressed, but going forward the reflection of transaction costs is likely to make this high yield index more realistic.

To be concluded

Noting the significant recompression of spreads since March 2020, we observe the trends that put today’s spread levels in context. Distress levels have peaked and defaults are expected to decline with a more benign environment to come. Historical trends toward higher quality within high yield were amplified by the 2020 environment, leaving today’s spreads relatively more attractive versus similar levels in the past. These trends are focused on the U.S. market, but so is high yield. The U.S. high yield market comprises roughly 80% of the global high yield market, making U.S. trends essentially global.

At an overall level, high yield valuations entered 2021 modestly wider than entering 2020. However, this masks nuance within the market. Higher quality segments offered more value, while the lower quality CCCs were meaningfully tighter. Though sometimes treated as a singular market, high yield has significant differentiation within it, offering value to be uncovered to the trained eye.

Option adjusted spread (OAS)

High yield quality segment
Overall HY

Developments in this market have implications beyond just the issuers and buyers of high yield securities. As high yield has trended higher in quality, these changes have altered the sector’s own risk/return profile as well as how it should be utilized within other fixed income strategies and in portfolios more broadly. At the same time, the level of negative yielding debt is significant and global rates remain frustratingly low for investors. This environment poses a significant challenge and is forcing investors to rethink fixed income. As investors rethink fixed income, understanding the state of high yield is imperative in addressing today’s income challenge and to successfully navigating the future of fixed income.


This report contains our opinion as of the date the report was generated. It is for general information purposes only and is not intended to predict or guarantee the future performance of any investment, investment manager, market sector, or the markets generally. We will not update this report or advise you if there is any change in this report or our opinion. The information, ratings, and opinions in this report are based on numerous sources believed to be reliable, such as investment managers, custodians, mutual fund companies, and third-party data and service providers. We do not represent or warrant that the report is accurate or complete.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a portfolio.

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties. High yield bond funds may have higher yields and are subject to greater credit, market and interest rate risk than higher-rated fixed-income securities.

ICE BofA US Corporate BB – B Index is a subset of the ICE BofA US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating BB – B.

The S&P 500® is an unmanaged index of large-cap common stocks. Investments cannot be made in an index.

Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

This presentation may contain targeted returns and forward-looking statements. ”Forward-looking statements,.” can be identified by the use of forward-looking terminology such as “may,.” “should,.” “expect,.” “anticipate,.” “outlook,.” “project,.” “estimate,.” “intend,.” “continue.” or “believe.” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties. This material does not constitute investment advice. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

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