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.

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.