Higher quality adding appeal to high yield

Bottom line up top:

Push or pull? Film fans of a certain age may remember "Doctor Dolittle" for its depiction of the Pushmi-Pullyu — a mythical llama-like creature with two heads, one at each end of its body, facing in opposite directions and stuck in a constant tug of war about which way to go. This may have had some whimsical appeal in 1967, but the pushes and pulls in today's financial markets do little to consistently please investors.

On one hand, recent U.S. economic data leans toward resilience. Job creation has been positive, though admittedly softer than the blockbuster gains in some prior years (Figure 1). And while monthly revisions to payrolls have skewed downward, a general sense of soundness in the labor market has tempered fears. Unemployment has dipped to 4.3%, with continuing jobless claims range-bound between 1.8 and 1.9 million, hardly recessionary levels. Meanwhile, year-over-year wage growth remains solid but not inflationary at 3.7%, and the Consumer Price Index for January came in at 2.4%, slightly below the 2.5% consensus forecast and closer to the Federal Reserve's 2% annual inflation target.

On the other hand, geopolitical conflicts, ongoing trade turmoil and elevated policy uncertainty in a midterm election year have led equity investors down a rougher road. By the end of last week, despite steadier performance on Friday, most major U.S. stock indexes had slipped into negative territory for the year. U.S. Treasuries also reflect push-pull tension. The 10-year yield has fallen 19 basis points (bps) so far in February, to 4.05%, benefiting from a flight to safety amid equity volatility. The 2-year yield, highly sensitive to Fed monetary policy, has dipped to near 3.4%. Anticipating two to three Fed rate cuts in 2026, markets are no longer pricing in a "higher for longer" environment, but neither do they expect a dash back to zero.

What's AI got to do with it? Shifting perceptions of how artificial intelligence may affect corporate profit margins, productivity and competitive viability have led to divergence as well. Depending on the day's headlines and quarterly earnings reports, AI sentiment has veered from extreme exuberance to deep doubt and back again, either rewarding cyclical equity market segments tied to capital spending and consumer momentum, or punishing certain industries seen as vulnerable to AI disruption, such as legacy software and business services. Investors are repricing not just earnings trajectories but business models, with strong balance sheets and durable free cash flow as the currency of conviction.

The Pushmi-Pullyu dynamics in U.S. equities and traditional fixed income create attractive opportunities to allocate outside of these asset classes. A case in point: high yield corporate bonds.

Portfolio considerations

Quality up, spreads down. Finding relative value in today's taxable fixed income markets can be tricky, as spreads remain historically tight. Credit quality and market dislocations are two key inputs when deciding where to initiate or augment non-Treasury sector exposure.

As an example, U.S. high yield corporate bonds have gone through a structural transformation since the 2007-2009 global financial crisis. Bonds rated BB (the top-quality tier for high yield) now make up more than half (roughly 57%) of the overall high yield market, versus 38% pre-crisis (Figure 2). This shift has translated into a default rate of just 1.9%, well below the long-term average of approximately 3.3%. In addition, nearly two-thirds (65%) of high yield issuers are publicly traded (according to Bank of America research). These are larger corporations whose governance and transparency requirements are more rigorous than those for other corporate credit asset classes.

When adjusted for today's higher-quality market composition, current high yield spreads of 280 bps (as of 13 February) should theoretically be even tighter - about 220 bps, based on our analysis. These spreads compensate investors well for the muted degree of default risk, even before factoring in the possibility of capital appreciation from further tightening.

Liquid market, solid alpha. Compressed spreads and public market volatility make this a credit pickers' market, providing potential opportunities for active managers to deliver alpha that might not be available in less-liquid, buy-and-hold asset classes. High yield bonds offer ample liquidity, with trading volumes of around $10 billion per day. This liquidity advantage may help support effective risk management in the event of market dislocations.

Lastly, high yield bonds have demonstrated resilience through both tightening and easing credit cycles. Their compelling income potential and relatively short duration profile can make them a worthy complement to traditional fixed income allocations.

Nuveen's Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.

Regular meetings of the GIC lead to published outlooks that offer:

• macro and asset class views that gain consensus among our investors
• insights from thematic "deep dive" discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
• guidance on how to turn our insights into action via regular commentary and communications