High-Yield Investing’s Unseen Opportunity

Like moths circling a bright light, high-yield investors are typically drawn toward the glow of large cap, high yield. But these investors might miss the potential opportunity lurking in the shadows: the small cap high-yield market.

“Small issues may offer high-yield investors much more of what they’re looking for: overcompensated credit risk, diversification and lower default rates,” says Robert Sydow, Portfolio Manager, Opportunistic High Yield at MetLife Investment Management.

Small cap high-yield investors have benefited for many years, as small cap bonds trade, on average, at yields 121 basis points higher than large cap bonds (based on Credit Suisse High Yield Index data from 2011 to 2024). But the scarcity of data around small issuers, perceptions around the small cap bond market, and scant company-specific knowledge have contributed to investors’ unwillingness to take advantage of opportunities in small cap, high yield.

“Those investors may be missing out on a large, enduring and exploitable market inefficiency,” says Sydow.

Companies that are prominent household names are associated with more data transparency, due to extensive equity research and news coverage. “Such transparency applies to large issuers’ high-yield bonds, too,” says Sydow. “Analysts have access to a wealth of standardized data that makes pricing them easier.”

Conversely, for a small issuer in a small industry, reliable data is harder to come by. “An analyst must do a lot more work to form an estimate of value and may lack confidence in that estimate,” says Sydow. “When investors aren’t confident of their valuations, they rationally build in an extra margin of safety in the form of a higher yield.”

Research from MetLife Investment Management shows that investors may have reason to increase their confidence in small cap, high yield—and to rethink their preconceptions. Many investors, for instance, hold an intuitive belief that large firms have lower default rates. Sydow doubted that hypothesis when his team launched a research project in the summer of 2022, and the results of the study, which covered 1999-2021, validated his view of small cap credit risk. 

“The data showed a different story,” he says. “A higher percentage of small cap companies do default, but when you measure the impact on portfolios, you have to count the dollars and not the events. When you weight the defaults by their sizes, large cap firms actually have higher default rates.” 

In fact, small cap high-yield bonds experienced a 16% lower average annual default rate than large bonds. 

“Furthermore, when calculating the annual average default rates on a market-size-weighted basis, instead of weighing each year equally, the dominance of small cap bonds is even greater,” Sydow says. Investors also typically view large cap bonds as the less volatile area of the high-yield market. But, in fact, “large cap bond prices are much more volatile on a week-to-week basis than small cap bonds,” says Sydow. 

The rapid-fire trading caused by “hot money” entering or redeeming from the large bond space creates volatility borne even by large cap holders who merely buy and hold. Small cap bonds, meanwhile, tend to “have prices that are governed more by economic value, not by immediate money flows, which results in more market value stability,” says Sydow.

MetLife research also shows that the small cap market can provide better diversification. When Sydow and his team looked at correlations of size cohorts in the high-yield market versus other asset classes, they saw an added diversification benefit of small cap, high yield for those also investing in the S&P 500 or Bloomberg US Aggregate Bond Index. 

“High-yield debt is a good diversifier, but small cap, high yield can be better than large cap,” says Sydow.

Given all the potential advantages offered by small cap, high yield, many investors still aren’t paying attention. Why? 

Default-rate data by issue size is laborious to create and not readily available, leading to a “continued bias against small bonds based on incorrect perceptions regarding default rates,” says Sydow. 

Additionally, investors often penalize small cap issuers for liquidity concerns that are exaggerated. According to Sydow, “Viewed properly in terms of average daily turnover as a fraction of the total issue size, small cap bonds trade only 14% less than large bonds; the perception is that the difference is much greater.”

For these reasons, investors are missing out. 

“Deeply discounted lunches aren’t common in public security markets,” says Sydow. But in small cap, high yield, “there’s potential to exploit a grossly undervalued and underfollowed segment of the market.”