The Fed’s big cut may favor high yield bonds

Key Insights

Historically, high yield bonds performed well after the first rate cut in a Federal Reserve easing cycle if that move was not followed by a recession.
The Fed’s large September cut improved the odds of avoiding a U.S. recession. Strong credit fundamentals and attractive yields are also supportive.

View Transcript

After a lengthy wait, the U.S. Federal Reserve began cutting interest rates in September. Many investors may be wondering how this could affect their investment portfolios—particularly their fixed income allocations.

Somewhat surprisingly, the Fed’s first cut pushed longer-term bond yields higher. The yield for the 10-year U.S. Treasury bond rose from 3.65% the day before the Fed’s decision to 3.77% a week later. Shorter-term yields, meanwhile, fell slightly.

This was probably due to the market’s perception of how the U.S. economy could respond to the Fed’s cut. While shorter-term yields are highly dependent on Fed expectations, longer-term yields typically depend more on market expectations for the strength of the economy. Clearly, the markets viewed a 50-basis-point cut as a reason to be more optimistic about the economic outlook.

As a result, bond investors may want to consider the appropriate mix between investment-grade, or IG, bonds and high yield bonds in their portfolios.

Historically, long duration IG bonds tended to be an excellent hedge against economic weakness but less attractive when the economy strengthened. High yield bonds, on the other hand, tended to benefit when the economic outlook improved.

The obvious question is: How have high yield bonds performed after the Fed has embarked on a rate-cutting cycle? A look at the historical record shows that outcomes have been quite mixed.

On average, high yield bonds, as measured by the Bloomberg High Yield Index, returned 4.44% in the 18 months following an initial Fed cut. But the range of outcomes has been very wide.

Not surprisingly, these outcomes depended heavily on whether a recession occurred in periods following the initial cut. In three out of the four instances where a recession did occur during the subsequent 18 months, high yield bonds produced negative double-digit returns.

Following the Fed’s first cut in August 2019, high yield bonds fell sharply once the COVID pandemic hit the U.S. economy six months later—although they bounced back quickly as the recession proved to be deep but very short.

Meanwhile, results for high yield bonds were very encouraging in periods where a Fed cut was not followed by a recession. In all three cases, high yield provided positive returns, most notably during the economic soft landings of the mid-1980s and mid-1990s. However, returns after the 1998 cut were more modest, as the economic outlook remained mixed and a recession eventually did occur in 2001.

An important factor that could provide comfort for high-yield investors now is that credit fundamentals still appear quite strong.

The various metrics used to gauge the health of the high yield market—such as interest coverage ratios, leverage ratios, and cash balances—have deteriorated slightly from their recent peaks but remain high by historical standards. This is typically not the case before the onset of a recession.

Interest coverage ratios are particularly insightful, as they illustrate how much cash flow companies have to cover ongoing interest payments.

As of June, EBITDA, or earnings before interest, taxes, depreciation, and amortization, was almost five times interest costs in the high yield universe—below the recent peak of 5.77, but above the highest level reached from 2008 through 2020. This is still true even if we adjust the EBITDA ratio to account for capital expenditures.

Lastly, high yield bonds currently offer attractive yields—not only relative to other fixed income assets but to equities as well.

One effective way to compare stocks and bonds is to look at the earnings yield for stocks relative to the yield to worst for bonds. Yield to worst is the lowest possible yield on a bond if it is called before maturity. At the end of August, the Bloomberg U.S. High Yield Bond Index offered a yield to worst of 7.3% while the earnings yield for the S&P 500 Index was only 4.7%.

Even if we ignore the impact of the so-called Magnificent Seven technology stocks, which pull the S&P 500 earnings yield lower because of their expensive valuations, high yield bonds now offer considerably more attractive levels of ongoing yield.

We believe the Fed’s recent dovish shift has increased the likelihood that a recession will be avoided over the near to medium term. This has important implications for fixed income portfolios.

If a recession is indeed avoided, high yield bonds may prove more attractive than longer-term investment-grade bonds over the next 18 months. As a result, our Asset Allocation Committee is maintaining an overweight position in high yield bonds.

After a lengthy wait, the U.S. Federal Reserve began cutting interest rates in September. Many investors may be wondering how this could affect their fixed income allocations.

Initially, at least, markets viewed the Fed’s first cut of 50 basis points (0.5 percentage point) as positive for the U.S. economic outlook. Longer-term yields, which are sensitive to changes in economic expectations, rose over the week following the Fed’s move.

Historically, long-term investment-grade (IG) bonds have tended to be an excellent hedge against economic weakness but less attractive when the economy strengthens. High yield bonds, on the other hand, have tended to benefit from economic strength. This being the case, bond investors may want to consider the mix between IG and high yield bonds in their portfolios.

High yield performance after Fed cuts

On average, the Bloomberg U.S. High Yield Index has returned 4.44% in the 18 months after the Fed has embarked on a rate-cutting cycle. But the range of outcomes has been very wide (Figure 1).

High yield performance after the Fed’s first cut

(Fig. 1) Performance of Bloomberg U.S. High Yield Index over following 18 months

Past performance is not a reliable indicator of future performance.
*First Fed cut is defined as the first month in which the federal funds effective rate fell 0.25% below the trailing 12-month peak.
Sources: Bloomberg Finance L.P. T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.

These results depended heavily on whether a recession occurred after the Fed’s initial cut. In three out of the four cases where a recession did occur in the next 18 months, high yield bonds produced negative double-digit returns. In the fourth case, after the Fed cut rates in August 2019, high yield bonds fell sharply once the COVID pandemic hit the U.S. economy six months later, but bounced back when that recession proved to be deep but very short.

Results were much more encouraging when an initial Fed cut was not followed by a recession. In all three cases, high yield bonds provided positive returns. But those gains were relatively modest after the Fed starting cutting rates in 1998, and a U.S. recession eventually hit in 2001.

High yield fundamentals appear quite strong

On the bright side, several key metrics used to gauge the health of the high yield market remain high by historical standards. This is typically not the case before the onset of a recession.

As of June, earnings before interest, taxes, depreciation, and amortization (EBITDA) were almost five times interest expense in the high yield universe—below the recent peak of 5.77 but above the highest level reached from 2008 through 2020.¹

This was true even after we adjusted EBITDA for capital expenditures.

Attractive yields versus equities

Lastly, high yield bonds now offer attractive yields—not only relative to other fixed income assets but to equities as well (Figure 2). At the end of August, the Bloomberg U.S. High Yield Bond Index had a yield to worst² of 7.3%, while the earnings yield for the S&P 500 Index was only 4.7%.

Yields are attractive on a relative basis

(Fig. 2) Equity, fixed income, and cash yields*

January 2010 to August 2024.
Past performance is not a reliable indicator of future performance.
* Yields for the Bloomberg U.S. High Yield Index, the Bloomberg U.S. Aggregate Bond Index, and Cash are yield to worst. Yields for the S&P 500 Index and the S&P 500 ex. Magnificent 7) are earnings yields.
^†The “Magnificent 7” are Apple, Alphabet, Amazon, Meta, Microsoft, NVIDIA, and Tesla. The specific securities identified and described are for informational purposes only and do not represent recommendations.
Sources: Bloomberg Finance L.P. and Standard & Poor’s (see Additional Disclosure).

Even if we ignore the impact of the so-called Magnificent Seven technology stocks (which pull the S&P 500 earnings yield lower), high yield bonds still offer considerably more attractive levels of yield.

Conclusion

We believe the Fed’s recent dovish shift has increased the likelihood that a recession will be avoided over the near to medium term. If so, high yield bonds could prove more attractive than longer-term IG bonds over the next 18 months. As a result, our Asset Allocation Committee is maintaining an overweight position in high yield bonds.

Timothy C. Murray Capital Markets Strategist Multi‑Asset Division

Tim Murray is a capital market strategist in the Multi-Asset Division. Tim is a vice president of T. Rowe Price Associates, Inc.

Sep 2024 • From the Field

Cutting cycles and learning to love bonds again

By Sébastien Page

¹ J.P. Morgan Chase North America Credit Research

² Yield to worst is the lowest possible yield on a bond if it is called before maturity.

Additional Disclosure

Bloomberg® and Bloomberg Indices are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the index (collectively, “Bloomberg”) and have been licensed for use for certain purposes by T. Rowe Price. Bloomberg is not affiliated with T. Rowe Price, and Bloomberg does not approve, endorse, review, or recommend its products. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to its products.

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2023, J.P. Morgan Chase & Co. All rights reserved.

The S&P 500 Index is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”), and have been licensed for use by T. Rowe Price. Standard & Poor’s^® and S&P^® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones^® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price’s product is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.

Important Information

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

Australia—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. For Wholesale Clients only.

Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.

EEA—Unless indicated otherwise this material is issued and approved by T. Rowe Price (Luxembourg) Management S.à r.l. 35 Boulevard du Prince Henri L-1724 Luxembourg which is authorised and regulated by the Luxembourg Commission de Surveillance du Secteur Financier. For Professional Clients only.

New Zealand—Issued by T. Rowe Price Australia Limited (ABN: 13 620 668 895 and AFSL: 503741), Level 28, Governor Phillip Tower, 1 Farrer Place, Sydney NSW 2000, Australia. No Interests are offered to the public. Accordingly, the Interests may not, directly or indirectly, be offered, sold or delivered in New Zealand, nor may any offering document or advertisement in relation to any offer of the Interests be distributed in New Zealand, other than in circumstances where there is no contravention of the Financial Markets Conduct Act 2013.

Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.

UK—This material is issued and approved by T. Rowe Price International Ltd, Warwick Court, 5 Paternoster Square, London EC4M 7DX which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.

202409-3881466