Investors who find value in high yield now likely would point to strong fundamentals, such as high earnings relative to interest expenses or other debt-related measures. While this is true, those fundamentals by themselves don't matter much, as historically, they've weakened significantly in recession. As we see potential for recession, we find high yield attractive for other reasons. Let's take a closer look.

The starting point matters in fixed income. The average yield for high yield bonds now sits at 8.5%, well over the 6 and 1/2% average since 2010. Importantly, we found that returns in fixed income markets can be largely explained by starting yields. This puts high yield in a pretty good spot, looking forward.

Further, we prefer structure over fundamentals. The quality of the high yield market, based on credit ratings, is at historically high levels. And lower-in-quality bonds are more secured, meaning protections in case of bankruptcy have increased relative to other securities on the balance sheet.

This is also, parenthetically, why we prefer high yield to bank loans. We think underwriting in the bank loan market will lead to poorer investor returns, as credit metrics have begun to deteriorate in this asset class.

Strong investor demand for securities with floating interest rates, such as bank loans, resulted in a reduction in investor protection, as the asset class grew 10% per year over the last decade. The result is a ratings mix for the loan universe that is at record low quality. Additionally, leveraged loans immediately absorb the impact of higher rates, another structural reason to favor high yield.

Prior market stresses have made high yield issuers stronger. The energy sector, a typical cyclical sector, would usually be vulnerable during recession. However, energy companies have shown financial discipline by cutting dividends and debt, while focusing on generating cash flow. So the energy sector has entered the year in a strong financial position. Further, the pandemic triggered retail and media defaults that would have likely been vulnerable going into recession, which reduces expected defaults going forward.

To assess the high yield market, economic scenarios play a key role. Right now, we think any recession is likely to be shallow in depth and short in length relative to past recessions. This means the cumulative default rate over any recessionary period is likely to be low. This means investors are likely to look through any economic slowdown and consider attractive yields, as we finally have the income back in fixed income.

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