The High Yield Market Outlook: How Fed Rate Cuts Could Drive Investor Returns

It was no surprise that the Fed cut the discount rate in response to improving inflation numbers, rising employment, weaker consumer demand, and credit—all in the hope of guiding the economy through a soft landing without causing significant disruptions to employment, credit, or the markets.

This raises the question: What happens to the high yield market when the Fed cuts the discount rate?

The charts above clearly show that as rates fall (as indicated by the forward 3-month T-Bill), assets under management (AUM) in high yield increase. The reason is clear: as yields fall on the front-end, investors chase the more attractive returns in high yield, as well as the potential for higher total returns, given that the duration of the high yield market is 3.5 years compared to just 0.25 years for a 3-month T-Bill. Morgan Stanley estimated that money market funds had AUM of $6.4 billion in July 2024, compared to $5.0 billion in July 2022. Forecasted money market yields suggest a 3% T-Bill by the end of 2025. Even a marginal shift of those funds could provide a strong tailwind for high yield.

But is it a good time to invest in high yield?

If yield spreads remain unchanged and T-Bills reach the 3% level by the end of 2025, investors could gain an additional 4% in carry. At the same time, lower rates will benefit many high yield companies, since 25% to 50% of their capital structures typically rely on floating-rate debt. Moreover, today’s credit markets are not signaling a recession. Lastly, as we’ve pointed out in the past, today’s high yield market differs significantly from previous periods of tight spreads:

Prices are lower today, providing more cushion against volatility. The average high yield bond price is currently 95, compared to 102-105 during the tight 2005-2007 period.
Credit quality is higher today, with over 50% of the market in BB credits, compared to 40% in the 2005-2007 period. Additionally, 35% of the bonds in today’s high yield market are secured, versus only 10%-15% during the tight 2005-2007 period.

In conclusion, a positive technical backdrop is developing in the high yield market that we believe should bode well for investors. While we acknowledge that spreads are tight, today’s market dynamics are much more favorable for investors than in previous periods of tight spreads.

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Data source as of 8/31/24: Citibank, Bloomberg, Morningstar High Yield category, H&W

You should consider the Hotchkis & Wiley High Yield Fund’s investment objectives, risks, and charges and expenses carefully before you invest. This and other important information is contained in the Fund's summary prospectus and prospectus, which can be obtained by calling 800-796-5606. Read carefully before you invest.

Investments in debt securities involve credit risk and typically decrease in value when interest rates rise. Investments in lower rated and non rated securities involve greater risk. The fund may invest in derivatives, asset backed and mortgage backed securities, and foreign securities. Please read the fund prospectus for a full list of fund risks.

This material is for general information purposes and should not be used as the sole basis to make any investment decision. Views expressed are not intended to be relied upon as research regarding a particular industry, investment or the markets in general, nor is it intended to predict performance of any investment or serve as a recommendation to buy or sell securities. Hotchkis & Wiley (“H&W”) is not responsible for any damages or losses arising from any use of this information.

The portfolio manager’s views and opinions expressed are as of September 12, 2024. Such views are subject to change without notice and may differ from others in the firm, or the firm as a whole. The portfolio manager’s comments may include estimated and/or forecasted views, which are believed to be based on reasonable assumptions within the bounds of current and historical information. However, there is no guarantee that any estimates, forecasts or views will be realized. In the event of new information or changed circumstances, H&W reserves the right to change its investment perspective and outlook and has no obligation to provide revised assessments and/or opinions.

Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. Certain information contained in this material represents or is based upon forward-looking statements. Due to various risks and uncertainties, actual events/results or performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.

Spread is the percentage point difference between yields of various classes of bonds compared to treasury bonds; Duration - measures the price sensitivity of a bond to interest rate movements; Carry - bond’s coupon divided by its price; Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services such as S&P, Moody’s and Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade; 3 Mo T-Bill 1 Yr Forward rate is the yield on the 3-month Treasury Bill one year from now; relates to the forward curve for US treasuries. Diversification does not assure a profit nor protect against loss in a declining market.

Past performance is not indicative of future performance.

Mutual fund investing involves risk. Principal loss is possible.
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