High-yield market: capitalising on valuation advantages in Europe

Even after the impressive rally of recent months, investors can still secure very attractive yields with high-yield bonds. Positive corporate results, solid fundamentals and low default rates contribute to our optimism about the asset class for the remainder of the year.

High-yield bonds have enjoyed a good start to 2024, with spreads narrowing by more than 30 basis points in the first two months, driven by positive corporate earnings news and solid growth figures in the US and Europe. Consumer sentiment has also been better than expected. This is reflected in the slightly more expensive valuations of high-yield bonds since the turn of the year.

The current situation is characterised by a sense of uncertainty regarding further macroeconomic developments and the future trajectory of interest rates. The most recently reported inflation figures were higher than anticipated, and it remains to be seen whether the soft landing in the US will come to fruition. In terms of monetary policy, the markets are now expecting fewer interest rate cuts by both the ECB and the Fed than forecast last year. However, it is advisable for high-yield investors not to focus purely on interest rate movements, but to look at the results of individual companies. For example, a stable cash flow is far more important for our investment strategy than interest rate expectations.

With a current yield of just under eight per cent (in US dollars) on the global high-yield markets, attractive returns are still available. In recent years, higher yields were only achievable in short (crisis) phases. Spreads are currently quoted at around 350 basis points (measured by the option-adjusted spread against government bonds). They are therefore slightly lower than the long-term average. This can be explained by the better quality in relation to the average rating in recent years and, also, by what we see as a constructive growth picture and generally good corporate balance sheets.

There are opportunities on both sides of the Atlantic. The US market is the significantly larger and more established market, and is characterised by a wide range of diversification opportunities. The comprehensive energy sector in particular distinguishes the US market from its European counterpart. The energy sector therefore remains one of our favourites, as it is less indebted due to the restructuring after 2020 and offers higher coupons than other sectors.

What is interesting at the moment is that we are seeing valuation advantages in Europe compared to the US. This has rarely been the case in our history of investing in high-yield markets, as the quality of companies in Europe is typically better, and it is therefore important to capitalise on this anomaly. Accordingly, we are currently overweight here and underweight in the US. Non-cyclical sectors, such as basic industries, in particular speciality chemicals companies, are also among our preferred areas. Attractive investment opportunities are also constantly opening up among the so-called 'rising stars'.

The property sector in Europe remains problematic. The high level of debt and insufficient rental income to service this debt are causing us to maintain our distance here. This also applies to CCC bonds, where we are strategically underweight as the significantly higher risk/reward trade-off is unlikely to pay off in the longer term. The proportion of CCC bonds has fallen significantly in the recent past and now accounts for less than ten per cent of the overall universe. This is an indication of the improvement in the general quality of the high-yield market.

We therefore do not anticipate a significant increase in default rates in the high-yield bond segment. Default rates are currently around three per cent but are likely to increase slightly over the course of the year. This would bring them in line with the long-term average. However, the defaults should mainly affect the lower-quality companies with higher debt levels. The corresponding bond prices there already clearly indicate the danger. Only in the event of unforeseeable exogenous shocks are further increases in default rates likely due to higher-than-anticipated risks. All in all, however, another positive year for high-yield bonds is completely perceivable, even after the strong year witnessed in 2023, primarily due to the attractive total return.