Default Not in Our Stars

We don’t think tariffs will cause a major spike in high-yield and loan defaults, and that means current spreads and yields look attractive.

In January of this year, high yield bonds were not very enticing. The option-adjusted spread of the ICE BofA U.S. High Yield Index was at an almost 20-year tight of 258 basis points.

Ten weeks later, in the aftermath of President Donald Trump’s April 2 tariff announcements, that spread had almost doubled to 461 basis points. Similar spread-widening has been seen in the Euro and Global High Yield indices. Those spreads have come in a little since, but all-in yield remains around 8%.

This looks like much better value—but, then again, the world does appear to have fundamentally changed. Do current spreads compensate for the heightened risks to trade and growth?

Impacts on Default Estimates

The short answer is yes, we believe so.

Once a quarter, our Non-Investment Grade research team estimates the likelihood of default for every issuer in the high-yield and loan indices. For our latest estimates, we reduced our U.S. GDP growth assumption to 0 – 1% and our European growth assumption to -1 – 0%. We also modeled the impact of the current global tariff regime. That pushed our estimate of the cumulative high-yield default rate for 2025 and 2026 to 3.75 – 4.75%, an increase of about 100 basis points on our estimates heading into this year.

Despite the low-growth and high-tariff assumptions, that default rate would be below the long-term historical average, reflecting the general rise in credit quality in the indices over the past 15 years: more BB rated issuers, shorter duration and more issuance used for debt-neutral refinancing rather than for leveraging acquisitions. In our view, this scenario would imply U.S. high yield spreads of around 350 basis points or tighter—not 400 or more.

In a downside scenario, we think the cumulative default rate could rise to as much as 9.5% over the next two years. That sounds high, but it is about the same as we experienced during 2019 – 20, and well below the 18%-plus of 2008 – 09 and the similar levels of 2001 – 02. With lower peak-default estimates in the downside scenario, we think high yield spreads will have difficulty staying above 600 basis points for any extended period, which makes the current level of around 400 attractive for starting to build allocations.

Quantifying Exposure

Given the scale of the shock to the global trade, and the volatility we have seen in equity, Treasury and currency markets, these estimates might seem surprisingly benign. But they make sense, in our view, because tariffs are unlikely to be a direct or substantial cause of rising defaults.

That’s partly because the sectors most exposed to trade costs and barriers—Autos, Retail and Consumer Products—represent less than 10% of the ICE BofA U.S. High Yield Index. But it’s also because most of the default risk we perceive emerges from deeper, structural challenges that long predate the recent tariff turmoil.

For example, Telecom and Media issuers have relatively limited exposure to trade-policy risks, but what they are facing is a cyclical downturn in advertising demand combined with changing media consumption patterns and tougher competition. Similarly, issuers in some Health Care subsectors are challenged by rising labor costs, a range of policy uncertainties and cutbacks in government spending. Looking across to the loan indices, we find more idiosyncratic, issuer-specific stress, mostly associated with highly leveraged, pandemic-vintage Technology LBOs.

Deeper issues are at play even in the Retail and Consumer Products sector exposed to tariffs. The high-risk issuers in this sector are struggling to adjust to consumers tightening their belts following high inflation, especially after they enjoyed a bump in demand around the pandemic. Some took on excessive leverage during the good times (and, too often, paired that with weak operational execution).

Quality

No one would argue that high tariffs and macroeconomic uncertainty are helpful for high-yield borrowers. Given this limited exposure in the high-yield market, however, we think direct impacts from tariffs are unlikely to trigger large-scale defaults. The most significant challenges for the small portion of at-risk issuers today are the same as they were four months ago: excessive leverage, stubbornly high rates, weak execution and structural sector headwinds. That is why our default outlook may not appear to match the scary headlines.

The most likely way the tariff regime would affect high-yield companies is through its impact on general economic trends—and with several years of conservative use of proceeds from new issuance and more BB rated issuers, we see those effects as manageable for the market. Issuers are strong enough to have reduced their 2025 and 2026 maturities by 70 – 80% in the past year, even though refinancing has meant paying higher rates.¹

With most issuers backed by strong balance sheets, we see ample places to put capital to work at attractive yields and spreads, even with a zero-growth outlook.