High-yield bonds: Yield extra, but the air is getting thinner
Normally, high-yield bonds have a significantly higher yield than, for example, government bonds from core Eurozone countries or corporate bonds from issuers with strong credit ratings. This is precisely what makes them so popular for many investors – even if the yield advantage is accompanied by higher and currently increasing risks.
The ratio of yield to risk in high-yield bonds (as with all financial instruments) is constantly in flux. Sometimes, one receives significantly more yield compensation than the realistically expected risks would suggest, and other times, it is too little. At the low point of the low-interest-rate environment, it was hardly possible to achieve positive returns or interest coupons even with high-yield bonds – a clear case of too little return for the risk. Fortunately, this has changed with the general rise in yields over the past few years and the widening of risk premiums for high-yield bonds.
Interest rates remain attractive at present
The market average for these bonds currently offers a yield of around 5.8% p.a. (as at the end of November 2024). However, the current market yield cannot be equated with the expected return, as possible default costs, among other things, must be deducted from this. Any price changes (e.g. due to changes in the general interest rate environment) can both increase and decrease the yield. In general, it can be said that the majority of any income on the bond market this year is likely to come from interest coupons rather than from further price increases.
Yield premiums below the long-term average
Spreads on the European high-yield market are currently below the long-term average. With a current premium of around 360 basis points, the European high-yield market is far from being at extreme levels, but rather at the lower end of the long-term range. This means that investors are being offered around 3.6% more yield than for German government bonds with a comparable term. However, this is only the market interest rate. The actual yield that can be achieved may deviate considerably from this under certain circumstances, for example if individual bonds default.
At present, the European market for high-yield bonds may not be extremely expensive, but it can certainly no longer be described as cheap. This is all the more true as an analysis of the index for the high-yield market as a whole only provides a very rough picture. If you exclude the ten per cent of bonds that trade with the highest yield premiums (i.e. those bonds that have the greatest default risks from today's investor perspective), the yield premiums for the remaining 90% are still significantly lower than 3.6%. The fund management currently continues to favour better quality issuers and short to medium bond maturities. Their yields are currently attractive compared to longer maturities and offer good returns for shorter capital commitments too.
Fundamental outlook currently slightly positive
This year saw a flood of new issues, with issuers with weaker credit ratings also strongly represented. On the one hand, this is good for their refinancing and liquidity. In terms of the high-yield bond market, however, it also means that the average credit quality of issuers will tend to deteriorate. Unlike in 2023, a sharply increasing proportion of new issues are no longer used solely for refinancing and thus to strengthen the financial power of companies, but the funds raised are also increasingly being used for company takeovers and mergers as well as dividend payments.
Although the market has so far coped well with the strong issuance activity (also because a significant amount of capital from investors has flowed newly or additionally into high-yield bonds), bondholders should critically monitor this development. It is very likely that the brisk issuance activity will continue in 2025, but it may possibly encounter overall lower buying interest than in 2024. At the same time, further interest rate cuts by the European Central Bank (ECB) and the US Federal Reserve (Fed), as well as declining inflation rates, should continue to support the market. Rating agencies currently do not expect a significant increase in default rates, but rather a slight decline. However, if the economy were to weaken more than expected, this assessment would be difficult to maintain, and high-yield bonds could come under selling pressure. While such an economic downturn is not the most likely scenario from today's perspective, it is certainly a possibility, especially since fiscal policy in some countries (USA, UK) could potentially pose headwinds for the economy.
All in all, euro-denominated high-yield bonds can still generate good additional returns, but the risks are increasing, and any returns are likely to come largely from interest coupons rather than further price increases of the bonds. In the past three years, investors in high-yield bonds have enjoyed strong additional returns compared to government bonds from core Eurozone countries with comparable maturities. It seems unrealistic to simply continue this trend. Any additional returns, if they continue to exist, are likely to be somewhat more modest than in recent years.
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