High yield bonds are positioning themselves cautiously in the spotlight as recession fears recede and credit quality improves. While junk bonds perform best during periods of robust economic growth, a region that’s closely flirting with a recession is seen as having the most potential.
The waning recession fears are a significant factor driving high yield into the limelight. A survey conducted by Bank of America among European fund managers reveals that 14 percent expect a global recession, down from 77 percent in the fourth quarter of 2022. If, due to the absence of a recession, spreads don’t widen, the current effective yield of 8 percent for global high yield is above average in historical perspective. Moreover, data from Bloomberg shows that with yields between 8 and 10 percent, the probability of positive returns over the next twelve months is substantial.
Nonetheless, the word “cautious” is never far from the conversations of Investment Officer with high yield investors. ‘The high yield market will remain volatile in the coming months. There is so much uncertainty in the world. The risk of a prolonged recession is still on the table,’ says Per Wehrmann of the DWS Invest Euro High Yield Corporate fund.
Nicolas Jullien, head of high yield & credit arbitrage at Candriam, also adopts a cautious stance. Like Wehrmann, he is one of the better-performing high yield portfolio managers over the past twelve months according to Citywire. ‘In the coming months, the consequences of higher interest rates for companies will become clear. In this late stage of the monetary cycle, caution and selectivity are warranted, especially in the United States where spreads are particularly tight. Certain sectors, such as the real estate sector, are facing challenges on both sides of the Atlantic.’
Client portfolio manager Rico Jumelet from Robeco adds, ‘We consider a mild recession likely in the US and Europe, partly due to the impact of the most aggressive interest rate hikes in the past 40 years and tighter lending policies by banks.’
Euro high yield offers the best opportunities
The three high yield experts assign the highest yielding euro-denominated bonds – a market worth 415 billion euros – the best opportunities. European junk bonds have performed less well than American ones in the past two years, making them cheaper. Additionally, Europe has swapped roles with the US as a ‘safe haven’ for high yield bonds. ‘The American high yield market was long considered safer, due to the war in Ukraine and the heavier weighting of energy. However, due to more attractive valuations and the decline in energy prices, the tide has turned in favor of Europe’, says Wehrmann.
Jumelet doesn’t rule out the possibility of energy prices rising again in Europe during the upcoming winter, impacting European producers. This could lead to a new resurgence of inflation, potentially prompting central banks to maintain tighter policies for longer.
On the other hand, credit conditions in the US are more constrained than in Europe, and several regional banks are facing challenges. ‘Comparing the US and Europe yields pros and cons for both markets. Therefore, it’s a matter of what the market has priced in. Both absolute spreads, spreads adjusted for the rating difference between the two markets, and the long-term spread ratio all favor European high yield.’
Improved credit quality is another factor
The European market is perceived as safer due to its better credit quality. The share of BB-rated bonds, the highest credit rating in high yield, has risen from zero to three-quarters in the ICE BAML European High Yield index since 1998, after Covid removed the weakest links from the index. The credit quality of the US high yield market – worth 1.416 trillion dollars – has also improved, albeit less dramatically. The ICE BofA US High Yield Index is now made up of 50 percent BB-rated bonds, compared to 43 percent at the end of 2011.
‘The European high yield market is dominated by BB-rated bonds, often issued by well-known companies such as Lufthansa, Renault, or Vodafone, some of which were investment grade. Additionally, the percentage of CCC and B-rated bonds is smaller than in the US. This provides reassurance to investors, even though the economic growth outlook in Europe isn’t rosy. The spread is genuinely good at this credit quality’, Wehrmann explains.
Jullien adds, ‘We expect BB-rated bonds to be the least affected by higher interest rates. In the B and CCC segments, some companies have such high debts that they wouldn’t generate positive cash flow with higher interest costs. You really need to thoroughly examine the balance sheets of these companies.’
Volatility continues to be a factor in the high yield market, according to both Wehrmann and Julien. Wehrmann states, ‘The default rate in Europe is now much lower than what spreads are pricing in, but the percentage is expected to rise to 2.5 percent over the next twelve months. More refinancing will take place next year, and some companies might struggle with higher interest costs.’ Julien remarks, ‘Financial markets need to adjust to the rapidly rising rates. This won’t happen without some volatility.’