High-yield bonds have long functioned as a carry-driven return engine in institutional portfolios, offering enhanced income and access to the corporate credit risk premium. Positioned between traditional fixed income and equities, the asset class has historically delivered attractive total returns through a combination of coupon income and spread compression. But with credit spreads now tight by historical standards, investors are increasingly questioning what role high yield can realistically play from here.
“Under normal circumstances, high yield provides that slightly diversifying, return-generating component. It’s primarily about carry, not diversification,” says Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Veritas. While high yield can offer some diversification versus equities, he cautions that “there’s a fair amount of tail correlation in the spread component to equities.” In other words, when risk assets sell off sharply, high-yield spreads tend to widen meaningfully as well.
“Under normal circumstances, high yield provides that slightly diversifying, return-generating component. It’s primarily about carry, not diversification.”
Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Veritas.
Decomposing Expected Returns
Iso-Mustajärvi evaluates the attractiveness of high yield by decomposing expected returns into two components: carry net of credit losses, and potential price returns from spread changes. On the latter, the outlook is limited.
“If you look at the historical spectrum of spread levels, we are at very tight percentiles regardless of the time window you pick,” he notes. “How much would you dare to assume that spreads might compress further, even in a constructive economic backdrop? Not terribly much, in all honesty.” The implication is clear: price return upside from further spread tightening is minimal.
“How much would you dare to assume that spreads might compress further, even in a constructive economic backdrop? Not terribly much, in all honesty.”
Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Veritas.
By contrast, the downside distribution is considerably wider. “If spreads widen to, say, 1,000 basis points in an extreme tail scenario, you’re looking at virtually equity-like drawdowns,” he explains. The skew of outcomes is therefore unattractive: the base case is earning carry, while the downside scenarios range from moderate losses to severe capital drawdowns. “The best case is really the carry scenario, and then you have various magnitudes of downside. That queue of outcomes is not particularly inviting.”
The Allocation Dilemma
The difficulty for fixed-income portfolio managers in the current environment, according to Iso-Mustajärvi, is there are few alternatives offering comparable yield within the liquid, “plain-vanilla” fixed-income space. “What makes the allocation tricky is that typically you need to be invested in the carry,” says Iso-Mustajärvi. Periods of tight spreads and supportive macro backdrops can persist for years. Forgoing 200-300 basis points of carry in the name of valuation discipline may result in prolonged underperformance versus benchmarks. “If you sit in cash waiting for a better entry point, it can be a very long wait.”
“What makes the allocation tricky is that typically you need to be invested in the carry. If you sit in cash waiting for a better entry point, it can be a very long wait.”
Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Veritas.
Rather than anchoring to historical allocations or benchmark weights, Iso-Mustajärvi prefers to assess whether other parts of the opportunity set can offer a similar carry profile with better asymmetry. One example is local-currency bonds in selected frontier markets, where yields may be more compelling relative to risk.
A Tilt to Europe and Nordics
Still, abandoning high yield altogether is not necessarily the base case. If exposure is to be maintained, the key question becomes where within the market the risk-reward is most favorable. Iso-Mustajärvi notes that Veritas is therefore heavily tilted toward Europe.
“If you look at single-B credits, you’re still getting roughly 50 basis points more spread in Europe than in the U.S., alongside slightly more conservative debt structures and shorter maturities,” he argues. For euro-based investors, the comparison is further affected by currency hedging costs. “On a hedged basis, you lose roughly 1.7 percent annually in running yield when hedging U.S. exposure. That eats into the risk-free component and leaves you with a view on Treasuries, which I find difficult to call at the moment.”
“If you look at single-B credits, you’re still getting roughly 50 basis points more spread in Europe than in the U.S., alongside slightly more conservative debt structures and shorter maturities.”
Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Veritas.
Iso-Mustajärvi also maintains a meaningful allocation to Nordic high yield, which offers additional yield pickup over the broader European index. The upside from price convexity may be more limited, given call protection features and the prevalence of floating-rate notes, but “the higher running carry remains attractive in a market with few obvious alternatives.”
Dispersion and Manager Flexibility
Despite tight aggregate spreads, dispersion within the asset class has increased. “The spread between triple-C and single-B credits is very wide, which means there is dispersion in the market,” he emphasizes. For a relatively small investment team like Veritas, this reinforces the case for investing through external managers, particularly flexible multi-asset credit funds.
Veritas typically selects managers with broad mandates across sub-investment-grade bonds, loans, CLOs, and occasionally preferred equity. In an environment where beta-driven returns are less compelling, alpha becomes critical. “When spreads are low and beta return prospects are muted, alpha becomes a much more important component,” Iso-Mustajärvi notes. Managers with the flexibility and analytical depth to rotate across instruments and capital structures are better positioned to exploit idiosyncratic mispricings.
“When spreads are low and beta return prospects are muted, alpha becomes a much more important component.”
Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Veritas.
He also points to evolving dynamics in the European loan market, including active CLO formation and the gradual adoption of U.S.-style liability management exercises (LMEs). As more aggressive restructuring techniques migrate to Europe, creditor-on-creditor tensions and complex capital structure negotiations are likely to increase. “I’m personally in the camp that the genie is somewhat out of the bottle. Not necessarily in the same way as in the U.S., but it’s coming,” he says. This further strengthens the case for credit teams with deep analytical resources and restructuring expertise.
Selectivity in the Lower Quality Segment
Opportunities do exist in selected triple-C names, particularly where technical factors such as CLO selling have created dislocations. But the margin for error is thin. “You need to be extremely selective,” Iso-Mustajärvi stresses. While Nordic high yield’s higher carry profile can compensate for some risks, the broader market remains characterized by relatively low dispersion outside a subset of more challenged issuers.
In sum, high yield today offers a classic late-cycle trade-off: attractive carry in the base case, but limited upside from further spread compression and meaningful downside in stress scenarios. For allocators, the question is less whether to own high yield and more how to own it: through regional tilts, careful instrument selection, and flexible managers capable of generating alpha in a compressed spread environment.
