High-yield market: Predictable cash flow beats lofty earnings expectations

The global high-yield market is proving resilient despite geopolitical uncertainty. The reason: companies are generating the cash flows they need to service their bonds. For bond investors, this is the decisive criterion, not the earnings expectations priced into equity markets.

Are investors underestimating the risks in the global high-yield market? Spreads stood at 296 basis points at the end of May, slightly below their level at the start of the year (304 bps), following a low of 284 basis points in January and a rise to 370 bps after the outbreak of the Iran conflict. This differentiation shows that the market does have the risks firmly in view. Valuations therefore appear fair.

The essential arguments for high yield, after all, have not changed: corporate balance sheets in particular are solid. In the US especially, a degree of euphoria is reflected in the high earnings expectations. Whether those figures are actually met is a question for equity investors. They are speculating on price gains arising from expectations being beaten. What matters more for the bond investor is whether they are compensated through the repayment of their capital and regular coupon payments. That does not require double-digit growth, but reliable cash-flow generation. And that is precisely what we currently see across the broad market, in the US as well as in Europe.

More attractive valuations in Europe
Regionally, the market expects a lower default rate for US high yield than for Europe. But companies do not usually default overnight; difficulties can generally be identified well in advance from bond prices. This is why the distress ratio matters more: it shows which part of the market is already trading at spreads of 10 percent or more and is therefore at risk of default. This ratio currently stands at a similar level in the US and Europe, at around 5 percent.

Even so, an overweight in Western Europe can pay off: these bonds are often more defensive, carry higher rating quality than their US counterparts and are in some cases better valued. When a company issues both a dollar and a euro bond with a similar maturity, the spread on the euro bond is frequently somewhat higher, which in turn reflects liquidity differences. This premium is correspondingly attractive. The higher US yields reflect interest-rate differentials; after a currency hedge, the net return is similar. An allocation to the US is therefore worthwhile above all where the aim is to deliberately exploit structural differences in market composition, for instance in the energy sector, which is considerably larger and more diversified in the US.

Sector selectivity: cash-flow quality over growth stories
At the sector level, opportunities currently arise in specialty chemicals companies that manufacture specialised intermediate products, face little competition, benefit from high barriers to entry and enjoy stable margins. There are also interesting companies in retail and telecommunications. While retail is generally a difficult terrain, certain niches are withstanding the pressure from Amazon and have so far proved hard to displace. Telecommunications is often a country-specific business that is little exposed to the economic cycle and therefore stable and resilient. Utilities are a different matter: the market currently credits them with structural tailwinds from the rising electricity demand of data centres and artificial intelligence. However, on the back of this positive assessment the sector is already trading at rather expensive levels.

Artificial intelligence: interesting, but selective
Artificial intelligence has only recently made its way into the high-yield market. Until now, technology groups such as Microsoft or Alphabet have financed their data-centre investments out of cash flow or via the investment-grade market. Increasingly, however, companies that build and effectively operate these data centres on an outsourced basis for those groups are coming to market in the high-yield segment. Many of them have concluded long-term contracts with their clients that are documented in the bond terms. This gives investors a degree of predictability and certainty regarding revenues.

Of the roughly 20 billion US dollars in expected AI-related high-yield issuance, around 15 billion has already been placed. Even so, the segment remains relatively small, accounting for less than five percent of the overall market. Some bonds offer attractive yields in the range of nine to ten percent. But not every issuer with an AI angle is automatically attractive. Many are listed on the Nasdaq, for example, and are therefore exposed to the heightened price swings of the tech sector: if the stock price falls sharply, the bonds react too. As more bonds from this area enter the market and valuations will have stabilised, opportunities can be assessed more accurately. Attractive entry points may then emerge.

This selective view of AI infrastructure is inseparable from the established software sector. While the market fears the displacement of software-as-a-service by AI, this concern appears overdone. The companies affected generate stable, recurring cash flows from licensing models, and so far this disruption is not discernible. For bond investors, what matters above all is whether cash flows remain stable and coupons can be serviced. That is likely to remain the case here.

Never two consecutive down years: US High Yield Index 1987–2026

^{Source: Bloomberg, ICE BofA. Annual returns of the ICE BofA US High Yield Index in USD hedged.}

Macro risks: high yield is no exception
The risks for the asset class are not to be found in the market itself, but arise from external shocks that would also affect other risk assets: geopolitical escalation or unexpected stagflation. Today's spread of just under 300 basis points prices in moderate scenarios, not extreme cases.

Nonetheless, there is a historical perspective that is relevant for long-term investors: the US high-yield index has existed for more than 40 years. Over that period, the asset class recorded only eight years of negative performance (the global index, which dates back to 1998, has had six negative calendar years). No two of them followed one another. In other words: Negative years were structurally always followed by a marked and swift recovery. High yield thus possesses a structural resilience that other asset classes do not have.

Conclusion: market knowledge is irreplaceable
The investment case for high yield remains intact. The asset class offers high running income, a short duration and, as shown, robust fundamentals. Compared with equities, the expected return is attractive by historical standards, while volatility is lower. What remains essential, however, is to separate and analyse individual business models, cash flows and valuations cleanly. A company with stagnating earnings growth but stable cash flows thus deserves the investor's attention. By contrast, boom companies with high expectations and volatile margins should invite scepticism. The value added by active management therefore lies in distinguishing one from the other, and in consistent risk management.