Don’t reach for yield: Why investors should be cautious about diving into low-quality credit today

As we discussed in our accompanying piece, bond yields have risen notably over the past year, lifting fixed income return expectations to their most attractive point in well over a decade. In particular, non-investment grade bonds are yielding north of 8% today — a rate that may seem compelling after years of lackluster bond portfolio returns. But is now an opportune time to invest in high-yield bonds?

We don’t think so. Absolute yields on high-yield bonds have risen sharply over the past year. But as illustrated above, the option-adjusted spread (OAS), which quantifies the additional yield they provide over similarly dated treasury bonds, remains in line with historical averages. At the same time, lending standards have been tightening significantly as Fed policy and growing recession risk puts pressure on both traditional banks and public lending markets. Historically, when lending standards meaningfully tighten, high-yield default rates have risen, pushing yields higher and lifting spreads to compensate investors for that additional risk.

In recent months, an unusual gap has developed between lending standards and spreads, suggesting that yields in the non-investment grade space may have room (perhaps quite a bit of room) to rise. That would result in downward pressure on prices for those bonds, as they adjust to current lending conditions and a potential economic slowdown ahead.

What’s the upside? Higher yields and wider spreads relative to Treasuries would create a more attractive entry point for investors willing to take on the additional credit risk. For now, we believe that high-quality core bonds offer a better value for investors and should offer greater diversification benefits if a more pronounced risk-off mood develops.