High yield bonds offer a certain extra return
High yield bonds generally have a much higher return than instruments such as government bonds from the core Eurozone countries or corporate bonds from highly rated issuers. This is exactly what makes them so popular among investors – even though the yield advantage is also accompanied by higher risks. The risk/return ratio for high yield bonds (just like any other financial instrument) is constantly changing. Sometimes you earn much higher compensation in the form of yields than the risks that are realistically to be expected would suggest, and other times it is not enough. At the low point of the low-interest environment, it was hardly possible to earn positive returns or coupons even with high yield bonds – a rather clear case of the return being too low for the risk.
Returns are still attractive at the moment
This has changed with the general increase in yields over the past two years and the widening of spreads for high yield bonds. The market is currently offering an average yield of 6.5% p.a. for these bonds(as of mid-January 2024). However, the current market yield is not the same as the expected return, as possible default costs, among other things, must be deducted from it. Any price changes (e.g. due to changes in the general interest rate environment) can both increase and decrease the yield. An expected (but by no means guaranteed) return of around 3.5% for the next 12 months is therefore more realistic. The actual result achieved can of course deviate from this and be either higher or lower. 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 rises.
Spreads below the long-term average
In terms of valuations, the overall European high yield bond market is roughly in the middle of its long-term fluctuation range as measured by spreads. The latter are currently at about 400 basis points, which means that around 4% higher yields are being paid per year than for German government bonds based on the market average. This is slightly below average by historical standards. Thus, the European high yield market is not yet exceedingly expensive at the moment, but it certainly can no longer be described as cheap, either. The fund management currently favours higher-quality issuers and short to medium bond maturities. The yields for these assets are currently attractive compared to longer maturities and offer solid earnings for shorter capital commitment periods.
Fundamental outlook moderately positive at present
Access to capital became more difficult and more expensive for issuers with weaker credit ratings in particular last year. However, interest rate cuts by the European Central Bank (ECB) and a widely anticipated decline in yields on the European bond markets could ease the situation for them somewhat again. At the moment, the rating agencies are no longer expecting a significant rise in default rates, but rather a slight decline. If the economy were to defy expectations and fall into a more substantial slide, this assessment would naturally no longer hold up and high yield bonds could come under selling pressure. However, such an economic downturn is rather unlikely as of now. The demand for euro high yield bonds from investors remains solid. As such, refinancing should be relatively easy for most companies. At the same time, only a relative moderate volume of bonds is expected to be issued beyond the refinancing of maturing bonds this year. This should also support the market.
Read more about the developments on the capital markets.