High Time for High Income

Gershon Distenfeld: Will, many investors are unnerved today. There are a lot of headwinds in markets. Despite that, we think there’s a pretty good opportunity in credit, particularly high yield. Why is that?

Will Smith: It’s for the very simple reason that companies came into this volatile period in really strong fundamental shape.

GD: Spreads have widened quite a bit here. Usually, widening spreads result in higher defaults. We don’t think that’s going to be the case this time. Can you elaborate on that?

WS: Absolutely. So, 2020 we had about 6% of the high-yield market file for bankruptcy. So, the weakest names just two years ago fell out of the investment universe, and the names that continue to be in the high-yield space survived COVID and have really improved their fundamental stories since then. So, when we look at the current economic slowdown that we expect, we actually think defaults will remain below average for quite some time.

GD: One of the lessons I’ve learned in my 25 years in the business is that attractive valuations could still get even more attractive in the short term, rich valuations, expensive valuations, can continue to do well, but there seems to be a much higher correlation with yields and longer-term returns.

WS: When you look at historical numbers, even if you were to buy a high-yield portfolio at a very bad point in the cycle—i.e., like, ‘07, bought a high-yield one at 7% yields—I think people are generally very surprised when I say after five years of being invested, you earned about 7%, even though spreads went a lot wider, we had big default rates. There’s a lot of things that happened, but at the end of the day, those all-in returns ended up being pretty close to your starting yields. And we think there’s no reason to believe that won’t hold going forward. For an investor that has a longer-term horizon, if you stack up those current levels of yields at 7% for high yield, we think that’s a pretty compelling value proposition over the next five years.

GD: Now, traditionally investors have viewed high yield as part of the fixed-income markets, rightfully so, they are fixed-income instruments, but one can make a compelling case that you should compare high yield to the equity markets because of the higher correlation there.

WS: Absolutely, and if you look at the history, it suggests that high yield is much more like an equity asset class than it is a government bond one. And when we think about today’s environment, for investors that want to de-risk their portfolio in some way, we think a very logical way to do that today is to actually reduce your stock portfolio, which might continue to be pretty volatile with all the macro headwinds that we’re facing. And instead replace it with a high-income-producing asset class, like high yield, that has significantly less volatility.

GD: One of the most frequent questions I get asked today is, given that rates are going to rise, why would I invest in fixed income now? Let me just wait on the sidelines and invest when yields go up even further. How would you respond to that?

WS: I think it’s a very dangerous game to play. When we’re talking about income-producing assets, your income accrues daily. And so every day you’re on the sideline, you’re missing that accrual.

GD: The passage of time is where you earn all of your return in fixed income, and just the odds of meeting your investment goals over any reasonable horizon is much lower when you’re not fully invested.