Dislocations create opportunities in US high yield

High yield versus leveraged loans and private credit

As floating-rate assets, leveraged loans and private credit have the wind at their back when the Federal Reserve is raising rates. When rate cuts are the focus, particularly due to a weakening economy, pressure will build on floating rate loans to below investment-grade companies. Lower rates mean lower yields on floating rate loans. In contrast, high yield bonds are fixed rate, and spread widening generally is cushioned by the decline in Treasury yields. From the February 19 peak in the S&P 500, the spread on the High Yield Index has widened by close to 200 basis points, yet the total return is down -3.3%, as of April 8, 2025. Some of that spread widening was cushioned by the 50-basis point decline in the 5-year Treasury yield since February 19.

Allocators still prefer CEOs and CFOs over politicians

The demand for low duration credit of any kind, including high yield, has been competitive since late 2023. This increased demand was met with muted net new supply as chief executive officers (CEO) and chief financial officers (CFO) focused more on preparing for potential recession and higher interest rates than aggressive capital allocation like debt-financed acquisitions, dividends, or stock buybacks. In effect, allocators want to bet on CEOs and CFOs rather than politicians. Inflows into high yield were high during 2024, even when spreads were narrow, because these allocations were strategic rather than tactical. We believe that in most cases these allocations were partial with the plan to add when spreads widen or yields increase. So far, that is what we have seen in 2025 as inflows into high yield have continued at competitive levels as spreads have widened.

Major changes in market structure create opportunities

Systematic, momentum, and passive investors have been increasingly influential in the high yield market, particularly in recent weeks. In a down market, assume there are two reasonably comparable bonds, but one is down one point and the other is down five points. What explains the four-point price dislocation? The systematic player is looking for weak small-cap stocks of companies that also have high yield bonds. Upon any fundamental hiccup, the systematic investor typically would short the stock and bonds, putting the company into a negative feedback loop. The stock is sold because the bonds are weak, and the bonds are sold because the stock is weak. Meanwhile, the passive player is a seller of both bonds equally to fund redemptions and replicate the benchmark. In this hypothetical example, the momentum player would short the bond that has sold off more because it is going down. Lastly, the active manager sells the bond that is down one point to buy the bond that is down five points. In recent weeks, however, the market has been dominated by the systematic, momentum, and passive players while the active managers have been less willing to step up.

Risk mitigation and opportunity identification

We are more cognizant of our exposure to the high yield bonds of public small-cap companies that have experienced fundamental hiccups. In our view, the prevalence of systematic, momentum, and passive investors in the high yield and equity markets in recent weeks has created dislocations and a negative feedback loop, particularly for companies with weak small-cap stocks that also have high yield bonds. In a situation like the current environment, we focus on risk mitigation and opportunity identification.

We have always preferred the transparency, price discovery, access to capital, and discipline of the public stock market. What we have found is that when a stock is down 25% to 60% in a quarter, the CEO’s family and friends, the Board, employees, customers, and suppliers all know it. Often, the CEO’s highest priority is to restore the confidence of the bond market to break the negative feedback loop of declining stock and bond prices. We believe this dynamic creates opportunities for active high yield investors. In contrast, we believe that CEOs of private companies are more likely to keep their foot on the accelerator because their stock valuation is not widely known. This thesis, which generally has served us well over time, will be tested in the coming quarters, but we are confident that it is justified.

In the middle of 2022, the High Yield Index bottomed at about a 600 basis-points spread and 9% yield. We believe that was a market that was priced for a very high probability of recession. We started to see capital from various sources, including some private equity capital, come into the high yield market. The High Yield Index has compounded at 8.2% since then. In late October of 2023, the High Yield Index was at about a 450 basis-points spread and 9.5% yield, and the market took off from there. The High Yield Index has compounded at 10.5% since then. We believe we are approaching a similar point today. Further, we continue to see opportunities, and we believe there are plenty of safe 7% bonds, lots of competitive 8% to 9% bonds, and some really interesting 10% to 12% bonds, which could have a materially higher internal rate of return. With the slowdown in earnings power, we find these yields compelling in an asset class that is tied to the balance sheet more than the income or cash flow statement like equities.

Nobody knows where current events will settle, but the financial markets, elected officials, the courts, public opinion, and plenty of other forces will come into play. This environment feels to us like one that leads to attractive returns for the long-term investor.