HY and IG Returns since 1997: Four Bubbles and Too Many Funerals

We look back at annual excess returns since 1997 through YTD 2024 as year two of the HY risk rally nears an end.

Dec 31, 2024

Well…that wasn’t so hard…

We look back across some extraordinary credit cycles since 1997 and frame annual HY and IG excess returns and total returns. The timeline includes bubbles in TMT, Structured Credit, Housing, and ZIRP-borrowing-dependency seen along with a total realignment of the global financial sector. For YTD 2024, we use 12-27-24 data.
The annual HY score sheet in excess returns over 28 years shows a positive vs. negative score of 17-11. That positive vs. negative mix reminds us that the rule of “getting paid more for taking more credit risk” does not always happen on a calendar year basis. The old commercial warning that “results may vary” applies to investment time horizons across the credit cycles.
The excess return pattern for IG is less pronounced and less volatile than HY but is in alignment with the same bad underwriting cycles and systemic stress (TMT, banks) as HY. We also see some years loosely in line with some industry concentration risk setbacks (e.g., energy in 2014-2015).
Both HY and IG got swept up in the setbacks of 2018 during the first major round of trade tension and risk of tariff and trade turmoil. We see both HY and IG feeling the effects of the tightening cycle in 2022 and the related cyclical anxiety.

The above details the swings in annual excess returns across the cycles since 1997. As noted in the bullets above, the score for HY excess returns weighed in across the 28 years with 17 positive and 11 negative in calendar year results from 1997 through YTD 2024 (12-27-24).

The YTD 2024 excess return is comfortable in the positive zone at +5.2%, so 2024 ranks 3 off the bottom among the positive return years at #15. For the full timeline, the YTD 2024 excess return ranks just below median for all 28 years.

The relatively low HY excess returns in 2024 come despite healthy spread compression that leaves HY OAS to end the year at levels in line with some past bubbles. That mildly favorable excess return performance offers a reminder of the “return math” challenge of coming off a very good year in 2023. The 2025 challenge will be how to start the clock at June 2007 and late 1997 type spreads and still measure up in the return history above.

As we see in the charts, it is tough to ring up 3 good years in a row without a minuscule positive year in the mix. We see that in the very bullish 2003 to 2006 stretch when 2005 barely made it into positive range when the market felt some major issuer effects and downgrades (notably large cap autos into HY).

We saw a trifecta of positive excess returns in 2019-2020-2021 as ZIRP and fiscal support was helpful in bolstering risk appetites in 2020 with a major late year rally on the vaccine news and the refi-and-extension boom underway.

The above chart looks back at annual IG excess, and we see 16 positive, 11 negative and one at zero. The YTD 2024 IG excess return was +2.9%. Among the 16 in positive range, that puts YTD 2024 at #9 among the positive return years but in a tight range with some years just below it.

The same history that we see in HY applies in IG also with respect to the challenge of notching a “positive excess return threepeat.” As in HY, we did see three positive years in 2019-2020-2021 with 2020 a fraction over the line. IG missed on the 2003 to 2006 stretch with the major downgrades into HY during 2005 by some mega-issuers (notably autos). Event risk was also quite high in that stretch. The 2004 to 2006 stretch all posted excess return years below YTD 2024.

Getting away from excess returns, the total return history chart adds the element of UST and duration impacts into the mix. We see the positive vs. negative score gets a lot better for HY, moving to 22-6 in total returns vs. 17-11 in excess returns.

The prolonged and aggressive easing policy rolled in by Greenspan after the TMT crisis shows up in the 2001 to 2004 stretch with easing continuing into 2004 or over 2 years into the economic expansion. The year 2001 saw an especially supportive series of monetary policy actions (see Greenspan’s Last Hurrah: His Wild Finish Before the Crisis 10-30-22). Not that anyone needs a reminder (I lived across the street), but the 2001 terror attacks on the WTC Towers gave way to multiple wars. Higher oil prices arrived (notably after Iraq in 2003), and plenty of UST borrowing needs came with it. The oil price backdrop fed into the investment frenzy in emerging upstream E&P technologies (the “shale revolution”) that fueled the later post-crisis HY sector growth and industry mix concentrations.

As a reminder, the Fed had already been easing frantically in 2001 and posted 7 easing moves before 9/11 and 4 more right after. The 2001 economic downturn (cyclical peak was March 2001, recession trough Nov 2001) was the mildest in postwar history. While the default rates were ugly in 2000 to 2002 on bad underwriting (and some deal chasing investments strategies), the broader economy was quickly back on track. The 2004 to 2006 tightening cycle was more about a bear flattening on the front end and less movement in the 10Y UST area.

The total return chart shows 6 straight years of positive total returns from 2009 to 2014 with HY spreads hitting a then-cyclical-low in mid-2014 (the later cyclical low was early Oct 2018). The Fed remained in ZIRP mode with bouts of QE along the way and ZIRP not ending until Dec 2015. The 2011 systemic turmoil roiled HY spreads (negative HY excess returns in 2011) but total returns were bolstered by the UST rally and HY total returns in 2011 were positive.

The UST market saw a bear steepener in 2013 on the “taper tantrum,” but the FOMC and ZIRP remained the HY market’s friend with HY total returns at +7.4% while duration pushed IG into negative total return range at -1.5%. Credit risk appetites were bullish, and 2012-2013 saw major rallies in the B and CCC tiers and a boom in refinancing. The refi and extension wave was in turn a self-fulfilling prophecy for market perception of lower credit risk on successful liability management.

The later 2014 to 2015 returns were marred by the energy sector crash that also hit a hefty base of BBB tier names. IG and HY both posted negative excess returns in 2015 and the same in total returns. ZIRP and low rates were already the reality. ZIRP ended in Dec 2015.

The above chart revisits the history of IG total returns from the late TMT period of credit excess into the FOMC tightening of 2000 and then a market crash. The tightening mix in 2000 ahead of the NASDAQ cracking quickly gave way to the Greenspan 2001 panic easing as the TMT default cycle spiraled. The score over 28 years was 21 positive and 7 negative. The 2022 duration pain drove a year in IG returns to over -15% or more than double the 2008 negative total returns.

The CCC tier was hammered for three straight years from 2000 to 2002, but the BBB/BB tiers also took beatings with names such as Enron (2001) and WorldCom (2002) collapsing among other crazy stories (Dynegy, Tyco, etc.). The “F word” (fraud) was alive and well and indictments made the headlines (Enron, WorldCom, Tyco).

The CCC tier has spent most of its history either first or last in excess returns and 2000-2002 saw the only CCC last place threepeat in excess returns (not shown). If we look at 1998-2002, the CCC tier was on the bottom for 4 of 5 years. Deals were aggressive and many blew up. Greenspan rode to the rescue in 2001.

The market saw 1% fed funds in 2004 (well into the recovery), and the stage was set for the credit excess that followed under the new Fed team (see Credit Cycles: Historical Lightning Round 4-8-24). Structured credit, a boom in CDS, and the soaring RMBS volumes came back to haunt the global financial system. Greenspan was hands off in terms of interconnectedness risk on the way to his retirement in early 2006 just as the housing excess was cresting.

The slow bear steepener of 2004-2006 was the last of the old school monetary cycles until 2022 (see Greenspan’s Last Hurrah: His Wild Finish Before the Crisis 10-30-22) but it came with waves of derivatives and counterparty excess that finally blew up in 2008. That set the UST markets on a trend of some form of accommodation (ZIRP, QE, brief normalization periods, and an inflated Fed balance sheet) until 2022 and the tightening cycle to fight inflation. The market even went into a full retreat into ZIRP with COVID in 2020 along with various market support programs to calm credit markets.

All things considered, IG has been resilient…

When you think about all that happened and all the distortions, the IG market “positive vs. negative” total return score of 21-7 is impressive. The worst year on the board for IG was -6.8% in 2008 before the -15.4% in 2022. That 2008 meltdown came with the correlation of banks and BBB industrials and with the HY markets and equity markets. Everything was collapsing in late 2008 and the bailouts kicked into high gear (notably banks and Fed engineered mergers with major securities firms ex-Lehman). The -6.8% total return in IG was a long way from the -26.4% in HY.

In general, the yield curve dynamics dominated the IG return stories of the 1980s and 1990s up until the onset of the 2007 disarray and emerging systemic credit crisis (see UST Curve History: Credit Cycle Peaks 10-12-22, Fed Funds vs. Credit Spreads and Yields Across the Cycles 6-19-23). We cover those histories in other commentaries (see links at bottom).

For HY, the devastation of 2001-2002 was old fashioned “defaults and bad credit” while 2008 started off as a mortgage and structured credit nightmare that cascaded into risk aversion, credit contraction, and an evaporation of secondary liquidity with fund redemption panics. The bank interconnectedness risk is mitigated in today’s market’s but still there.

It is still easy enough to make a lot of bad loans with a lot of downside risk, but the market is not at that point in the credit cycle either even if there will continue to be warnings around private credit excess with “uncertain” quality of marks and/or reserving policies in the system.

As we head into 2025, the excess return risk-reward symmetry is unfavorable. The duration risk factor turns on exploding deficits and UST supply and the extremely aggressive tariff and deportation game plan that we view as extremely damaging if Trump goes ahead as threatened.

The good news is that the FOMC has dry powder for crisis management. That is, unless the crisis is self-inflicted by trade policy and fiscal actions. Lower rates can even weaken the dollar and make imports even more expensive on an all-in basis with tariffs.

Contributors:

Glenn Reynolds, CFA

Kevin Chun, CFA

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