Systematic Insights: Stress-testing high yield | Insight Investment

We previously highlighted our analysis indicating that time in the market may beat timing the market in US high yield. We concluded being invested means accruing coupons, but waiting for entry points means not accruing coupons, often making the former more lucrative.

Since then, the “Liberation Day”-related market round trip (and now fresh legal wrangling over tariffs) reminds us that timing may be particularly hard right now, as none of us have prior knowledge of policy announcements (or when and how much they might be blocked or walked back). So, with the understanding that forecasting is hard, is now a good entry point, from a value perspective? In other words, do current yields offer sufficient compensation for default risks and uncertainty?

Is a ~7.5% yield still good value in high yield?

Insight’s current base case is for an economic slowdown (but not a recession) from the current level of ~2% GDP growth (year-on-year).

On average, 0% to 2% GDP growth has been a sweet spot for US high yield versus equities and investment grade (Figure 1). Slowing economic growth on average implies slowing profit growth (frustrating equity investors), but not an impaired ability to repay debt.

Figure 1: Insight’s base case could be positive for high yield¹

But what if we are wrong? We see the probability of a recession at around one in three. And although less likely in our view, inflationary and stagflationary scenarios would likely be more punitive, implying rising rates, credit spreads and defaults (Figure 2).  

Figure 2: But what if our base case is wrong?²

Under our assumptions, a shallow recession would drag US high yield total returns down to ~5% over the next 12 months, close to current investment grade yields of 5.3% (albeit investment grade may benefit from its higher duration exposure and less spread widening relative to high yield in a recession).

The inflation and stagflation scenarios would, however, be enough to bring 12-month US high yield total returns close to zero (Figure 3).

Figure 3: Inflationary or stagflationary crises would potentially result in a muted forward 12-month total return³

In conclusion, a starting yield of ~7.5% may offer enough of a cushion to compensate investors through a recession and an inflation crisis, and almost enough to compensate for a stagflation crisis over the next 12 months. In this scenario, high yield would of course be expected to continue to deliver income after the 12 months are over, potentially aiding in any recovery.

In our view, particularly given our base case of a moderate slowdown in the US economy, high yield may be an attractive investment in the current economic landscape.