2025 High Yield Bond Outlook: How the Beat Could Go On

In Brief

A supportive macro environment, still mostly disciplined corporate behavior, and accommodative financial conditions suggest default loss should remain low in the year ahead. Current carry is a good starting point in estimating forward-return opportunity as a result.
Spread valuations are close to historic tights (unadjusted for positive evolutions of duration and credit quality), but they can remain so for multiple years. Dispersion in CCCs suggests the cycle has more room to run, but risk management will create alpha.
We’re being mindful of the risks to our constructive view: They include a potential widening breadth of credit destructive behavior by issuers, prospects for rising political and regulatory uncertainty, and a U.S. Federal Reserve (Fed) that may need to respond to inflationary impulses that ultimately turn stagflationary.

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2024 proved to be another strong year for risk-asset returns, and U.S. high yield was no exception with the ICE BofA U.S. High Yield Constrained Index returning 8.2%, led by CCCs returning 16.4%. A similar story played out in the bank loan space with the Morningstar LSTA U.S. Leveraged Loan Index slightly edging out high yield bonds at 9.0%, collectively pointing to the resilience of leveraged credit broadly. The start to 2024 still exhibited some investors’ residual concerns around a delayed impact of the Fed’s hiking campaign on economic growth, despite the December 2023 pivot. But flash forward to today, and credit spreads across investment grade and high yield are optically once again near multi-year tights, and supportive growth ahead is now the consensus, even as the Fed is now poised to be less dovish than most expected this time last year.

This combination of valuations and sentiment leaves the credit market outlook call in a trickier spot than this time a year ago. However, we believe high yield credit is poised to put forth another year of solid returns. Below, we go through the elements of that supportive view, ending with a discussion of what may derail our base case.

Starting Point: Yield Not the Whole Story, But It Helps Explain Historical Returns

Throughout the year, many of our client conversations were a debate about what should matter more to end investors—all-in yields or credit spreads—as the rally in credit spreads more than offset the modest climb in Treasury yields over the year. Credit purists among us would favor the latter as more relevant, as credit risk premia are how credit investors get compensated for relative liquidity, ratings drift, and default risk. But lost among these debates is the reality that the default loss, as extrapolated from a consistently declining default rate through the past year, came in lower than most anticipated at the start of 2024. We’ll have more to say on the default outlook ahead, but in Figure 1, we note that forward returns, when starting yields hover in the current context, have been supportive. And we think this approach is particularly relevant today, given the sustained and meaningfully below-average default rate environment we see for 2025.

Figure 1. History Suggests Attractive Forward Returns at Today’s Starting Yield

Moves in benchmark yields will matter, but think more carry than spread compression ahead

Line Chart showing moves in benchmark yields

Source: ICE Data Indices LLC. Data as of December 31, 2024. U.S. high yield is the ICE BofA U.S. High Yield Constrained Index. Forward cumulative index returns are not annualized and were calculated when the index yield-to-worst (YTW) was at or above 7%. Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset class depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Defaults: Expecting Another Decline in the Default Rate for the Year Ahead

There are any number of detailed approaches that can help construct a default rate forecast. However, we find that focusing on the distress ratio can be both simple and useful, with the distress ratio defined as the portion of the high yield market par value trading at a credit spread of 1,000 basis points (bps) or greater. That’s an approximate marker for when credit investors start to shift their return expectations of a credit—from one that is more coupon oriented—to pricing in some probability of restructuring and what asset value may remain for creditors.

In Figure 2, we track this distress ratio through time as well as the actual default rate over the forward 12 months at each point. A useful general rule that falls out is that the forward default rate has historically been about 1/3 of the starting distress ratio. Applying that approximation to the current distress ratio of 4% would suggest a default rate of just above 1% for 2025. That’s close to the level of the past year, and again meaningfully below the long-term average. Keep in mind that this approach of looking to the distress ratio at the start of 2024 modestly overestimated the actual default outcome.

Figure 2. Falling Distress Ratio Implying Even Less of Headwind to Returns from Defaults

The distress ratio has been closely correlated to the forward default rate.

Line chart showing falling distress ratio

Source: ICE Data Indices, LLC and Bloomberg. U.S. high yield distress ratio data as of December 31, 2024. 12-month forward U.S. high yield default rate data as of November 30, 2024. In this context, “distressed” refers to issues with an option-adjusted spread of 1,000 basis points (each basis point is one-one hundredth of a percentage point); the “distressed ratio” represents the percentage of the high yield market trading at those spread levels. Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset class depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

There are a few reasons beyond the supportive macro setup that explain the pricing of a muted default outcome for the coming year, including but not limited to:

Nearly 54% of the high yield bond market is rated in the BB-category, a historically high proportion when excluding the $200 billion+ deluge of fallen angels from BBB to BB at the onset of the COVID pandemic. This composition reflects issuer-weighted gross leverage of public high yield issuers sitting just above the lowest levels post the great financial crisis (GFC).
Accommodative capital markets have allowed issuers to refinance upcoming maturities, with only 5.4% of the high yield index due to mature through mid-2026. Most, but not all, default candidates are typically CCC-category-rated one year prior to default, and the market value of CCC-rated debt is at 12.1%, barely off the 20-year low of 10.3% recorded in 2020.
A record 80% of 2024’s issuance use of proceeds was to refinance debt, per J.P. Morgan. Potentially credit-destructive uses of debt capital, including outsized and late-cycle capital spending, financing of special dividends, share buybacks, and acquisitions, remain well suppressed, although this is something that we are certainly monitoring.

Valuation: Spreads Far off the Most Compressed Levels Where Market Turns Typically Occur

Despite these observations around fundamentals and default expectations, it’s hard to argue the positives aren’t already mostly, if not fully, reflected in credit spreads today. As a result, the spread tightening story of 2024 won’t serve as a playbook for 2025. But in Figure 3, we track the spread dispersion of the high yield CCCs versus the overall level of credit spreads. Note that at each major sell-off or turning point in the credit cycle, credit spreads were far more compressed and lacking in dispersion than we observe today. We believe that compressed credit-risk premia environments highlight the underlying high level of investor complacency, indiscriminate extension of capital to strong and weak credit profiles alike, and hence the end of cycle conditions setting the stage for a turn wider in spreads. This lack of dispersion is hardly the case today, arguing for an extension of the credit cycle in our view. But it does favor taking an active approach to the asset class where a successful investor can properly look to avoid owning those credits that may ultimately serve as the problem credits when the cycle turns.

Figure 3. High Yield Valuation Still Fairly Disperse; Watch CCC Dispersion for Cycle End

Major credit spread turning points typically come when valuations are far more compressed.

Source: ICE Data Indices LLC and Bloomberg. Data as of December 31, 2024. CCC dispersion defined as proportion of face value marked +/-400 bps outside of the ICE BofA CCC & Lower U.S. High Yield Constrained Index. Dispersion in OAS for U.S. high yield (HY) and CCC-rated bonds refers to the range or variability of the spreads within these categories. The OAS measures the difference between the yield of a bond and the yield of a risk-free Treasury bond, adjusted for embedded options. Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset class depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Away from the dispersion observation, two other points can help calibrate and explain today’s overall spread levels:

As noted earlier, the composite credit ratings of the high yield asset class is near a record high. If we were to apply today’s credit ratings mix to the historical spread tights of 240 bps in mid-2007, that adjustment alone would argue for the broader high yield index spread level being approximately 20 bps tighter than what was recorded at that time.
Like the secularly improving credit profile of the high yield asset class, it’s also gotten much shorter in duration over time, falling from an average maturity of approximately 8.4 years in 2006 to under 5 years today. That shortening maturity profile results in less default risk over the duration of a bond, all else equal, and argues for tighter spreads.

What Could Go Wrong?

Yes, there’s asymmetry around credit spreads residing near historic lows and already pricing in the continuation of a benign credit environment. So, risk management and gauging the potential for left-tail events is more important now than this time last year. A few developments, beyond garden-variety recessionary concerns we’ll be watching for, as signals to potentially moderate our constructive view include:

Mergers and acquisitions (M&A) financing rising, but it could persist for years before becoming problematic: Commentary from investment banks reflects expectations of rising M&A and leveraged buy-out (LBO) volumes in the years ahead, given the views of sustained growth and a more relaxed regulatory framework under the new administration. But if we look to history, high yield financing of acquisition activity rose annually for nearly four years, from 2003 to 2007, and six years from 2009 to 2015, before crises hit the credit markets. Every cycle will be different, but we think the breadth of corporate aggression will matter more than just a rise in strategic and buyout activity.
We’re all understating the regulatory and political uncertainty: The incoming administration is poised to follow through on many campaign directives including spending cuts, imposing tariffs, immigration reform, and mass-scale deportations. In 2024, credit and equity volatility continued their retreat toward post-COVID lows even as rate volatility didn’t fully retrace, allowing risk assets to perform well. But political and regulatory uncertainty could serve as a catalyst to inject volatility back into risk markets, depending on the extent and speed of execution of those directives.

For example, focusing on tariffs, just given the composition, issuer size, and scope, we’ve largely considered the U.S. high yield market as less exposed to tariff-related concerns. Energy, basic industry, media, healthcare, and leisure, as the largest sectors in the high yield market, arguably have less supply chain and profit challenges that could be directly sourced from tariffs than traditional manufacturing and/or globally oriented businesses. But second-order impacts that present stagflationary impulses for the economy broadly would be problematic for risk.
Inflationary impulses lead the Fed back to hiking mode: All year, we’ve argued that the pace and depth of Fed eases mattered less to high yield than the powerful easing of financial conditions attributable to the Fed’s late 2023 pivot that set a path of easing outright. However, rising policy rates would be risk-sentiment negative and more importantly, once again raise the cost of capital that could pressure weaker credit that has been thrown a lifeline from the open capital markets.

Summary

Even with a nuanced and multifaceted outlook, we remain optimistic about the potential for high yield credit to deliver solid returns in 2025. The resilience shown by leveraged credit in 2024, demonstrated through strong returns and stability despite market fluctuations, coupled with supportive macroeconomic conditions and historically low default rates, underpin our positive view. However, we acknowledge the heightened need for vigilant risk management, particularly in light of potential left-tail events and evolving market dynamics.

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About the Author

Sean Carroll, CFA

Product Specialist

Sean Carroll is a Product Specialist responsible for covering Lord Abbett’s Leveraged Credit and Global Equity strategies. In this role, he is responsible for developing investment narratives, marketing materials, and strategic plans for our products across retail and institutional channels.

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Glossary & Index Definitions

A basis point is one one-hundredth of a percentage point.

Carry is the difference between the yield on a longer-maturity bond and the cost of borrowing.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed--income investment to a change in interest rates.

The Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value.

The ICE BofA US High Yield Index tracks the performance of U.S. dollar-denominated, below-investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one-year remaining term to final maturity.

The Morningstar LSTA Leverage Loan Index is a benchmark that measures the performance of the U.S. leveraged loan market. It is co-branded by Morningstar and the Loan Syndications and Trading Association (LSTA). This index provides comprehensive and precise coverage of the leveraged loan market, tracking the performance of loans that are syndicated, traded, and rated by credit rating agencies. The index is widely used by investors to gauge the performance of the leveraged loan market.

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