In January 2022, the Federal Reserve Board (Fed) began increasing the U.S. Federal Funds rate in response to elevated inflationary pressures. Headline Consumer Price Index has increased 570 basis points (bps) to 7.1% over the past two years, prompting the Fed to increase its Federal Funds rate by 425 bps in 2022. The upper bound of the Federal Funds rate is currently 4.50%, with expectations that the terminal rate may exceed 5.00% in early 2023. The current monetary tightening cycle is the most aggressive in the Fed’s history.
The aggressive monetary policy actions have caused mortgage rates to increase 340 bps to 6.67% and the U.S. treasury yield curve to invert as short-term interest rates have risen more dramatically than long rates. A deceleration in housing activity and yield curve inversion have historically been harbingers of economic contractions, leading to speculation that the U.S. economy may be headed into a recession. Over the course of 2022, the chance of a recession in the next 12 months have increased from 10% to 62%, according to the U.S. Recession Probability Forecast data obtained from Bloomberg.
Given the increased recessionary concerns, we thought it would be helpful to address the question: How does high yield perform in a recession? Reliable return data for the high yield market only goes back to 1985, limiting our recessionary period observations to the last four; 1990, 2001, 2007 and 2020. We used National Bureau of Economic Research (NBER) recession period definitions and looked at the rolling 12-month returns for U.S. treasuries, investment grade corporate bonds, A and BBB rated corporate bonds, and the high yield market for the 24-month periods before and after each recessions trough. Given the varying lengths of these four recessions – 8, 8, 19 and 2 months, respectively, we normalized the recession periods into deciles to facilitate comparability.
Charts 1 through 4 below compare the 12-month rolling returns for the four selected fixed income asset classes for the 24 months prior to and after each of the last four recessions. We use this basis as it most effectively approximates a 1-year holding period.
Chart 1: 1990 Recession
The Fed began gradually lowering the Fed Funds rate in June 1989, a year ahead of the NBER’s July 1990 recession start date. The Fed continued to ease throughout the NBER’s March 1991 recession end date. High yield underperformed as the Fed began easing and continued until October 1990, about halfway through the recession. In our view, the 1990 recession, which encompassed Iraq’s invasion of Kuwait, is most like the current economic environment.
Chart 2: 2001 Recession
The Fed began lowering the Fed Funds rate in March 2001 coincident with NBER’s recession start date, and continued easing until June 2003, well after the NBER’s November 2001 recession end date. High yield began underperforming in January 2000 and flipped to outperforming (after a double bottom) in July 2002. The 2001 recession included both the 9/11 terrorist attacks, the TMT bubble burst and the Enron bankruptcy.
Chart 3: 2007 Recession – Global Financial Crisis
The Global Financial Crisis (GFC) was long (20 months) and deep (10% unemployment rate peak). It was the most severe recession since the Great Depression and included a confluence of major capital market and real economy contractions. The Fed began easing in September 2007 (Fed Funds target at 5.25%), three months before the NBER’s recession start date. The Fed’s easing continued until December 2008, at which point the Fed Funds Rate was 0.00%. The recession continued until June 2009. High yield underperformed across the entire period of Fed easing. Only when the easing cycle ended did high yield start outperforming the other fixed income asset classes, approximately 6 months before the end of the NBER defined recession period.
Chart 4: 2020 Recession
This recession encompassed the COVID-19 Pandemic but was short (2 months), severe (13% unemployment rate peak), and involved significant unconventional monetary and fiscal policy measures. After engineering a soft economic landing in 2018, the Fed began easing in July 2019, seven months prior to the NBER recession start date of February 2020. Easing ended in March 2020 when the Fed Funds Rate was back to 0.00%. High yield began underperforming one month prior to the NBER recession start date and began outperforming one month after the NBER recession end date of April 2020.
Chart 5 isolates the last four recessionary periods’ 12-month rolling return data for the selected fixed income asset classes and normalizes them into deciles to facilitate comparability.
Chart 5: Average Returns
Through this lens, it underscores general tendency toward high yield underperformance during a little over the first half of the last four recession period deciles. This makes sense insofar as these periods include earning declines, corporate balance sheet stress, and elevated defaults. These factors typically result lower government yields and significantly wider option-adjusted spreads (OAS) for high yield bonds. These periods also tend to involve a great deal of government intervention directly from Fed easing and more indirectly though government spending on programs aimed at stemming the economic contraction. As rates fall, government and higher quality corporate credit benefits. It is only after spreads peak that high yield assets tend to benefit in the form of outperformance compared to these other asset classes. This back-end outperformance of high yield is most apparent in the 1990, GFC and 2020 recessions. The 2000 recession was really complicated by the Telecom, Media and Technology contraction of that period which delayed high yield’s ultimate outperformance.
In conclusion, high yield tends to underperform during the front end of a recession. Government and higher quality credit are the first beneficiary of the falling rate structure that tends to coincide with economic contraction. It follows that as the momentum of the downturn dissipates, high yield spreads peak and the combination of much higher running yields and ultimately a degree of spread compression produces significant outperformance for high yield in the last stages of a contraction.
Our current view is that there is a strong possibility that we will experience some form of economic contraction in 2023. It stands to reason that we can expect a rough approximation of the previous behavior to follow (i.e., high yield will probably lag high quality fixed income in the early stages of that slow down). Several caveats should be placed on this expectation. First, if the slowdown is mild, the spread widening will be modest and there is a good chance that high yield will benefit more than investment grade credit due to the combination of near simultaneous interest rate and spread compression. Second, the previous recessions outside of the recent COVID-19 period typically involved extensive dislocations across the entire financial system, which ultimately produced significant increases in defaults and massive spread widening (e.g., over +1000 bps OAS). As a matter of expectation, we do not see that kind of broad, deep contraction as a very high probability. Moreover, the high yield market’s internal characteristics are higher quality than any point in the last twenty years. As such, we believe any spread widening will likely peak well inside those previous periods, say +700-800 bps. Thus, while recognizing the potential headwinds of a 2023 slowdown, we remain constructive on high yield by anchoring on a combination of valuation and quality that we think will ultimately deliver both nominal and relative outperformance at some point during the year.
