Has U.S. high yield been impacted by recent market volatility?

Source: ICE BofA US High Yield Index, S&P 500 Index, Russell 2000 Index, as of March 20, 2025. Past performance is not a guide to future performance. There is no guarantee that the market will experience the same momentum as in the past few years. It is not possible to invest directly in an unmanaged index.

As we see it, the U.S. HY market – unlike equity markets – did not necessarily need GDP growth keep pace with last couple of years to support current valuations, despite having a relatively high correlation to equity markets over the medium to long term. For the HY asset class, a low, positive GDP environment could potentially offer a constructive environment in which HY companies still have enough room to operate and grow revenues. This compares favorably to a much hotter economy, which can have a negative impact on the higher quality, more rate sensitive securities within HY, as well as lead to excessive corporate exuberance. We believe a low, positive GDP

environment could compare favorably to a recessionary environment which can lead to balance sheet deterioration and a pick-up in defaults.

At the March FOMC meeting, the Fed revised its GDP expectations for 2025 down by 0.4% to 1.7%, but it still expects around 1.8% over the longer term. In our view, this 0-2% range is perfectly fine for HY. Further, this divergence with the equity outlook has been reflected in the comparable volatility that the two markets have recently experienced.

Turning to valuations and after initially tightening in January to a low of 259bps, spreads have risen by 58bps from that low to 317bps as of 3/20 (Chart 2). This reflects a modest widening from historically tight levels but only gets us back to where we were in September. At the start of the year, we believed spreads would likely come under pressure at points throughout 2025 given the extent of the compression we have witnessed. However, that ultimately would still reflect both the recent strong fundamental and technical backdrop, as well as longer-term structural changes in the market (better liquidity, record low duration, improved credit quality, higher % of secured).

A counterargument could be the equity market would naturally react first to a deterioration in the outlook, but that potential contagion may lie ahead for credit spreads. We acknowledge these concerns and see some validity in some recent sell-side reports revising spread forecasts modestly wider in the near term given increased uncertainty and continued volatility in the Treasury market. However, we still believe spreads will remain well supported after any sell-off, given the amount of cash on the sidelines and investors who have been waiting for better entry points. Importantly, we have not seen anything in the past few weeks to change our view on defaults, which is ultimately what spreads are compensating investors for.

The HY bond par-weighted 12-month trailing default rate as of February 2025 was 0.3% (excl. distressed exchanges) and 1.3% (incl. distressed exchanges). This compares to a 25-year average (incl. distressed exchanges) of 3.4%. Apart from the expected distressed exchange transaction to be

completed by Altice France (SFRFP) later this year, which should add around 50-60bps to the “incl. distressed exchange” default rate when it goes through, we do not see any other large candidates for default that have the potential to move the needle right now. It is worth noting that the SFRFP exchange is already priced by the market and so the impact on overall market valuations should be minimal. In summary, a default rate in the region of 1-3% (incl. distressed exchanges) for 2025 still seems the most likely scenario to us, which remains in line or below long-term historical averages.

Technicals have also started the year on a strong footing, with resilient demand, deals over-subscribed, and a lack of anticipated M&A related new supply potentially pushed out for now due to the tariff uncertainty.

We have also seen inflation expectations being revised up, given the potential for weaker migration that is likely to keep the labor market tight and the introduction of wide-ranging tariffs, which should put pressure on international supply chains and lead to higher domestic prices. On tariffs, we consider the U.S. HY market to be quite well insulated from escalating trade wars, given its domestic focus. As the chart on the left below shows, U.S. domestic corporates make up 85-90% of the broad U.S. HY index and some sell-side reports estimate that less than 15% of U.S. HY company revenues are generated abroad. This compares to investment grade which has a greater proportion of multi nationals and 27% of non-U.S. companies.

That said, indirect impacts could come through supply chain disruption and a decline in business and consumer confidence, particularly given the potential inflationary feed through from tariffs. In our view, the HY sectors most at risk from escalating trade wars include Autos, Retail, and Consumer Products. For now, guidance from companies as to H1 earnings has been coming down overall. Many companies are in “wait and see” mode for H2 if more clarity emerges, which may allow them to make decisions around the size of their workforce, the amount of capex they are willing to commit, and investments they are able to make.

In our view, it is worth emphasizing that, historically, the HY market has been a relatively inflation-proof asset class over the long term. The charts on the right below show that the U.S. HY market has been one of the few fixed income asset classes to have generated a positive total return after being adjusted for CPI inflation in the 3-year period to January 2025, which has seen the highest inflation prints in a generation. At the bottom, the chart shows the U.S. HY market and S&P 500 index deflated by CPI inflation over a 25-year period, where until 2019 the U.S. HY market was even outperforming the S&P 500 after adjusting for inflation. HY has a shorter average maturity and a lower duration than other fixed income asset classes, meaning it will generally be less negatively impacted by a tightening in monetary conditions (e.g., higher rates) instigated by central banks to combat inflation than higher quality fixed income. We believe this offers the potential for the HY credit premium embedded in the spread to generate positive real returns over the medium term.

Source: LSEG Workspace Datastream, ICE BofA, Bloomberg. (1) ICE BofA, as of February 28, 2025. (2) As of February 27, 2025. * Estimation made by JP Morgan Research in U.S. Credit Impacts of Trump’s Economic Proposals, as of July 30, 2024. It is not possible to invest directly in an unmanaged index. Past performance is not a guide to future performance.

Potential areas to consider across U.S. high yield

In this environment of uncertainty, we believe it may be worth investors considering a short duration approach. Short duration bonds, by their nature, can offer investors a more defensive investment at times of market stress. U.S. short duration high yield also makes up about a third of the overall U.S. HY market and, as such, can offer investors a liquid asset class in the largest and most established high yield market.

While we expect the Fed to cut rates, right now, despite recent U.S. Treasury curve steepening, the HY yield curve is still relatively flat. This means that for more defensively minded approaches there may still be potential opportunities in the current market. Alongside this, if the market does not perform as well as expected or is too aggressive in its expectations for rate cuts, then a defensive short duration approach may be able to protect on the downside. If the market performs better than expected like the last couple of years, then such approaches could potentially capture 75-80% of the HY market return, in our view.

While spreads are on the tighter side of historical averages, we believe yields remain attractive. Wee this yield driving the return for short duration. In our view, spreads are likely to be relatively range bound during the year but will experience volatility and could very well finish the year slightly wider. However, we think this is unlikely to have a material impact on shorter duration securities.

So, in summary, we believe short duration approaches could offer a nice balance of potential outcomes in a wide range of economic scenarios and have the potential to protect investors against both interest rate volatility and spread volatility.