It has been a volatile year for high yield bonds. Heightened uncertainty gripped the world following Donald Trump’s radical tariff propositions announced in early April, triggering a selloff in risk markets. However, markets quickly recovered, and high yield spreads now hover near historical tights.
This bullishness reflects investors’ optimism that Trump will not take actions that jeopardise risk markets, which is widely referred to as the “TACO”1 trade by investors and the media. Although Trump’s administration has temporarily eased pressure on trading partners regarding tariffs, we believe the U.S. economy is not out of the woods yet.
Spreads look too tight when considering macro risks
Credit market segments: short bar = the asset class is more expensive relative to last 20 years
Negotiations with major trading partners such as China and the EU are ongoing, and the only finalised deal so far is with the UK. Even if agreements are reached, some residual tariffs may remain, as seen in the UK’s experience. There’s also the risk that negotiations could collapse. While these scenarios could hinder economic growth, the market seems to be acting as if the tariff risks have already disappeared.
Additionally, there is a possibility that the U.S. government could shut down over the summer unless the debt ceiling is raised and a new budget is approved by Congress. Investors appear to interpret an expansionary budget as a positive for risk markets, as increased government spending injects liquidity into the system. However, this could stoke fears of an unsustainable deficit, and the rise in long-end Treasury yields this year reflects those concerns. Higher yields directly increase borrowing costs, potentially slowing economic growth.
Given the political and macroeconomic tail risks under Trump’s presidency, we believe high yield spreads are tight relative to the level of uncertainty. The current complacency among investors presents an opportunity for active managers like us to identify and exploit market mispricings. Today’s high yield market includes segments that we find expensive from a spread perspective and thus less attractive. Conversely, sectors facing negative sentiment, such as energy, offer potential for contrarian trades. The rise in oil prices due to the ongoing Israel-Iran conflict could give a fillip to the sector.
We also see value in the U.S. healthcare sector. Toward the end of last year, regulatory and political concerns triggered a selloff in the sector’s bonds. As political tensions ease, the attractiveness of healthcare bonds could rise. At the same time, CCC-rated bonds and cyclical sectors are likely to be more vulnerable in the event of a sharp economic downturn.
We believe Europe remains compelling relative to the U.S. Investors are highly bullish on U.S. risk markets despite the ongoing trade war. Meanwhile, Europe’s macroeconomic environment is improving, supported by fiscal stimulus and declining interest rates.
Good returns for HY normally come from current yields
Global High Yield Markets: 12 months return distribution when yield to maturity has been between 7% and 8%
Although high yield bond spreads are towards the tight end of historical ranges, the all-in yield remains relatively high, and this coupon income provides the prospect for continued steady returns. Relative to equities, high yield provides advantages such as low duration, seniority in the capital structure, and relatively low volatility. Even so, our guiding principles at this time are “prudence” and “patience”, as investor complacency remains widespread, with many discounting the potential for negative developments.
Credit selection is crucial in this environment. We manage a high-conviction portfolio—typically fewer than 200 companies—and continuously seek bonds that provide an optimal mix of attractive yield for acceptable risk, and alignment with our ESG criteria as an Article 8 strategy. We view credit spreads as compensation for an uncertain future. Thus, we seek a margin of safety when taking on risk—highlighting the need for investment discipline when (as happens periodically) the market becomes more expensive. We have a clear strategy to reposition our holdings and capitalise on volatility whenever such opportunities emerge.
1 Trump Always Chickens Out
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