US high-yield bonds benefit from improved quality and demand

Talking Heads with Jack Stephenson

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors.  In this episode, we’ll be discussing US high-yield. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Jack Stephenson, Investment Specialist for US High-Yield.  Welcome, Jack, and thanks for joining me.

Jack Stephenson: Thank you, Daniel.

DM: If we think about where we are today, if we particularly look at spreads for US high-yield, we’re not so far off from where we were prior to ‘Liberation Day’. So, we’ll talk about that. But let’s begin with the macro-outlook for next year. Can you share your expectations for the US economy next year?

JS: If you look at the US high-yield market return year-to-date, the market is on for a simple coupon-type return of around 7%. But of course, we’ve seen at the macro level that pendulum swing from a lot of enthusiasm at the start of the year right to that more draconian situation that markets priced in in April. Since then, it’s been a one-way trade. You could be forgiven for thinking a market’s complacent because we still have all these big themes on the macro level growth, inflation, tariffs and also the labour market that are concerning investors.

At the same time, on spreads, markets appear priced for perfection. So, what are the markets missing that’s macro is not pointing towards. Well, we still see a constructive environment for US high-yield. We’re expecting slower growth in the next couple of years than we’ve seen in previous years. We’re coming from a strong base of 2.9% GDP growth in 2023 and 2.8% in 2024. It’s only natural that we see cyclical normalisation. We believe that GDP growth is going to be in this 1/2 to 2% range, which is supportive for high-yield.

Why is that? Well, because high-yield doesn’t necessarily need the superstrong growth that equities tends to enjoy. That tends to lead to excesses, whether it’s too much leverage or share buybacks, none of which is particularly good for bond holders. Having this kind of controlled slowdown, which we believe we’re going to be in for the next couple of years, is really the sweet spot for high-yield. It allows issuers to grow EBITDA, to grow revenues without the extremes of either of those more extreme scenarios. So, overall supportive on the GDP front.

I think inflation, there’s definitely concerns there. We are starting to see tariff-related inflation, which is leading to stickier core CPI. We also have dynamics in the labour market: a withdrawal of labour supply which could coincide with that tariff-laced inflation to keep inflation stickier and higher than the Fed’s target for longer.

And then we have to consider all the AI spend that’s going on around the US economy, which we expect to have a materially positive impact on growth in the short and the long term and therefore will put further upwards pressure on inflation. We still have some concerns there, but there’s enough in the labour market to give the Fed further impetus to cut rates into 2026, which we believe will continue to be supportive for all fixed income markets.

DM: I would imagine when you’re talking to clients, one of the first concerns that they raise that spreads are quite low, at least compared to history. How worrying is that to you?

JS: I’m not going to tell you spreads are cheap. Clearly, they are not by any metric, but the first point that I would look to is longer-term structural trends in the high-yield market whereby we’ve seen improvements towards a much better quality market. Investors might still think of the high-yield market as the junk bond market. But what we’ve seen over a 15-year time period is the market moving gradually up in quality during that low interest rate era. We today have 55% double Bs relative to 37% before the global financial crisis. We have only 10% triple Cs in the index relative to 16% before the global financial crisis. So, from a ratings composition perspective, it’s moved up in quality.

We’ve also seen more recently more secured bond issuance. That’s been one way that issuers have been able to minimise overall interest expense. Some of that has been coming back from the leveraged loan market, which has had tremendous growth over the last 10-15 years. We also have record low duration, a lot of high-yield companies moving up to investment-grade has meant among other reasons much lower duration in high-yield today, which is anyway a shorter maturity asset class. And then much improved liquidity. So, structurally, we are talking about a market which should justify a tighter spread level and should lead to a lower ceiling in spreads when we see sell-offs and we saw that ‘Liberation Day’. That’s the longer-term theme.

Secondly, more recently, we’ve seen positive trends over the last five years or so in terms of the proactivity that many companies showed when rates were low in 2020/2021, locking in a low cost of interest expense, pushing out their maturities. We’ve been coming off record-high levels of interest coverage, record low levels of leverage in the high-yield market.

The technical environment has also been strong. By that, I mean sources of demand outstripping supply over the last few years. One of those sources of demand has come in the form of rising stars, a lot of debt leaving the high-yield market to become investment-grade that has not been replaced by fallen angel companies coming from investment-grade into high-yield through downgrades. So, the market has been shrinking. We’ve also had less new issuance in a year like 2022 when we saw interest rates going up and companies could afford to wait to issue bonds, which they’ve been doing definitely this year. September, we saw it on the month, [was] the fourth-largest month for high-yield issuance ever. Crucially, although we’ve seen a pickup in issuance recently, net suppliers remain low. When we’ve seen issuance, predominantly it’s been for refinancing purposes. On average about 65 to 70% of the issuance that we’ve seen in recent years has been for refinancing purposes.

DM: If we think about corporate earnings, another worry that’s investors have is around tariffs. That’s
going to have an impact on US companies as well to the degree that they’re going to be importing any goods into their production process. If you look at the recent earnings season and the impact of tariffs on earnings, how do you see the outlook?

JS: Tariffs has a material impact on the global economy, let alone in the US. There’s been better news on that front over the summer. We’ve seen deals made with the EU, with China. But all of that said, we are seeing the impact of tariffs play out at the individual sector and issue level. I would split those impacts into direct and indirect impacts. The direct impacts are coming through in sectors that rely more on global supply chains. So, retail, consumer goods, paper packaging, autos. There’s definitely being more direct impact on those types of companies and sectors.

However, predominantly,  the US high-yield market is domestically focused. There’s been research suggesting that around 75% of US high-yield company earnings are generated within North America. If we look at sectors like services, technology, telecom, these sectors are much more domestic.

So, where I talk about the indirect impact, if we were to see a more generalised consumer slowdown in the US, considering that the consumer accounts for roughly 65% of the overall US economy, that would be more of a material concern. We do see more pressure on the consumer., particularly lower income consumer, particularly when you look at deceleration in wage growth among that cohort. That’s having an impact on parts of more cyclical industries that will rely on discretionary spend from that lower income consumer. We see that in retail and parts of leisure, but I would describe that as mixed impacts. We see parts of consumer-facing industries also still doing well.

So, overall, when it comes to earnings, I would describe it as still positive from a top-line growth perspective, but some erosion in bottom-line. When our analyst team is looking at company earnings overall, we would say the company has delivered okay earnings, but guidance is down, or cash flow is negative. That’s the type of mixed impacts that tariffs is having at the moment.

DM: Let’s end up with the opportunities that you see across the investment landscape. Are there any industry sectors where you see particularly good potential?

JS: Firstly, even though spreads are tight and we expect them to remain in a relatively tight range, spreads won’t just trade in this range forever. We will see opportunities due to the amount of uncertainty at the macro level. Secondly, yields remain attractive in US high-yield and that’s both on an absolute basis around 7%, but also relative to other asset classes and definitely cash. A lot of investors in cash have been looking for a new home. The yields in US high-yield do compensate investors for a lot of that uncertainty at the macro level.

Digging into your question, we love to talk about US high-yield as not being one asset class. Too often people think of high-yield as being this asset class where either you have exposure or you don’t, whether you’re either overweight or underweight versus your benchmark. What we try to speak to investors about is there are many different ways in which you can use this asset class both to reflect your outlook and your risk appetite, but also to complement other asset classes. One of the major benefits of US high-yield is that diversification quality, being able to produce equity-like returns, but with much lower volatility, while having a shorter maturity than investment-grade, being able to complement high-quality parts of fixed income. So, it plays a unique role in a diversified portfolio.

At the more individual issuer level, there are some large capital structures in the US high-yield index that contributes around 40 basis points to the overall index yield. I would describe those capital structures as being relatively stressed or distressed and they come in sectors such as media, telecom, healthcare. This is both a risk and an opportunity. There’s the risk in shorter timeframes that we see a lot of the market return being driven by these specific stories. We try to pick our spots in these types of large capital structures. That comes down to the bottom-up credit work. Sometimes, it means being positioned within the secured part of the capital structure where we feel there’s a more attractive risk-reward opportunity. Sometimes, it means not owning the name at all.

DM: If I could summarise some of the key points. If we think about the macro-outlook, you’re constructive and actually slower growth in 2026 is the sweet spot for high-yield. On the one hand, concern about inflation, but pointing out that the Fed is likely to be cutting rates next year. When we talked about valuations, you pointed out that’s at least partly explained by the higher quality of high-yield bonds today and there are technical factors supporting the market. Finally, when we think about the impact of tariffs, you highlighted that high-yield companies tend to be more domestically focused or less exposed and in general, interest coverage looking quite good. Well, Jack, thank you very much for joining me.

JS: Thank you very much, Daniel.

DM: That’s it for this week’s episode of Talking Heads. If you would like more information about our capabilities in high-yield, please reach out to your asset management contact. We recommend subscribing to Talking Heads on your favourite podcast channel such as YouTube or Spotify. You’ll receive your podcast episodes every week. If you’d like Talking Heads, leave us a positive review and a nice rating. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Daniel Morris, and Jack Stephenson, Investment Specialist for US High-Yield. Please do join me next week. Until then, take care.