Don't Chase Yields

Performance by Rating Bucket: Quality Wins Over Time

Recent data from Bloomberg shows that in 2024, lower rated high yield bonds outperformed, with Single-B and CCC bonds returning 5.2% and 15.0% on an excess return basis, versus 4.8% for BB rating bonds. Yet when taking a longer-term perspective this is not the case:

• Over the past 20 years, to the end of 2024, BB rated high yield bonds earned an average annual excess return of 3.6%. In addition, BBs had the highest Sharpe ratio (0.85) – that is the return adjusted for volatility - outperforming the rest of the high yield market.

• The high yield market as a whole, produced an excess return over the time period of 3.6%, which is in line with BB rated bonds, but with a weaker Sharpe ratio (0.76). In other words, the lower quality parts of the market are bringing the Sharpe ratio down.

• Single-B bonds, over the same time frame, were the worst performing segment of the high yield market, with an excess return of only 2.8%.

• CCC bonds were the highest performing with an excess return of 4.7% per annum. However, the volatility was much higher with a Sharpe of only 0.76. Importantly, the CCC universe is very difficult for investors to replicate as many bonds enter the index as they become distressed, and many bonds drop out as they go into default and restructure. In other words, given the difficulty in replicating such a universe, the achievable return is likely overstated.

In summary, while lower rated Single-B and CCCs can shine in the boom years, data shows BB rated credits have delivered superior performance on an excess return basis and risk adjusted basis (Sharpe) over the full cycle.

Default & Recovery: The Harsh Reality

Investors drawn to headline high yields often underestimate default risk:

• Historical average default rates over one year, according to Moody’s: ~1% (BB), 4% (B), 16% (CCC).

• Moody’s “5 year default” data: cumulative default rates ~0.18% (AAA), <10% (BB), and in excess of 40% (CCC).

In addition, restructuring outcomes for lower-rated credits tend to deliver poor recoveries, often well below par, leaving yield-hungry investors nursing heavy losses.

Overall lower-rated high yield bonds carry a significantly higher probability of default and restructuring. Even in periods of economic growth, idiosyncratic risk in the lower tiers of the high yield market remains elevated, driven by poor governance, cyclical revenue models, and weak balance sheets.

Drawdowns & Volatility: Not Just Yield on Tap

High yield as an asset class offers lower volatility than equities, but risk diverges sharply across ratings:

• CCC bonds underperform sharply in downturns. In 2015 during the commodity crises CCCs saw a drawdown of around -28% versus only -8% for BB rated bonds. Again in 2020 during the covid pandemic, CCCs had a drawdown of about -27% versus -18% for BB rated bonds.

• In addition, the time CCC bonds stay underwater is a lot longer. In 2020 during the covid pandemic, the sell off begun at the start of March. By mid-July BB bonds had recovered all their losses – that’s only 4 months. However, CCCs took about 2x as long to recover, with the bonds moving back into the black in November of that year.

• CCC bonds in general are much more volatile than the rest of the high yield market, with a standard deviation of returns of 11.40%.

Drawdowns in CCCs are deeper and slower to recover—tragic if clients redeem at the bottom.

Takeaways

• In our opinion, over the long run it’s best to focus on BB rated HY bonds — they have historically delivered solid income with gentler drawdowns and stronger recoveries.

• At the same time we think it wise to avoid risky single-Bs and CCCs – they tend to be yield traps with a higher risk of default, restructuring risk, and thin recoveries. Although CCC bonds provide occasionally explosive returns, they come with crippling tail risk. There is no “free lunch”.

• Yield without quality is a trap. Sustainable income comes from building resilient, well positioned portfolios anchored in credit selection—not chasing the highest yield.

The New Capital Global High Yield Positioning

• Although all in yields are currently attractive in the 7% area, credit spreads are currently on the rich side based on history. As such, it’s even more paramount than ever to not reach for yield and to stay disciplined.

• The New Capital Global High Yield Bond Fund is focused on being high quality, such that it is positioned to be more resilient in a downturn in our opinion.

• The Fund is overweight BB and above rated bonds versus the index by around +25%.

• And underweight single-B and CCC bonds by around -25%.

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