High yield bonds: Europe currently more attractively valued than the US

First the good news: High yield bonds have never had two negative years in a row. Although we do not expect a huge rebound after an almost unprecedentedly weak 2022, we are cautiously optimistic that the historic pattern will remain in place in 2023. The first half of the year nevertheless looks set to be rather more difficult, with many companies having to cope with declining profits as a result of weak (or negative) economic growth and inflationary pressures. We therefore expect spreads to widen in the first six months, before narrowing again in the second half of the year.

While high yield issuers still look to be in a fundamentally good position, we expect this situation to deteriorate to some extent. Although debt is unlikely to increase, a drop in EBITDA will lead to a higher debt ratio, while the rise in interest costs will impact free cash flow. We therefore expect default rates to climb this year – probably to around 4% in the US and Europe. In emerging markets, meanwhile, default rates should remain around 10%, mainly as a result of further defaults in the Chinese real estate sector. A sharp rise in default rates does not appear to be on the cards, as the number of bonds maturing in 2023 is still relatively low. Being unable to repay or refinance debts that are reaching maturity is still one of the main causes of default.

We also expect both the number of rising stars and fallen angels to increase this year, or at least remain at a high level. Although it may seem paradoxical at first, this contrasting development can be explained by two different factors. In 2020, we saw a record number of fallen angels. Although many were upgraded again in 2022, further significant upgrades are expected in 2023 – particularly in the energy sector, but also in the case of a major automotive company. This is likely to lead to a reduction in the weighting of the energy sector within the index, even though it is still expected to remain the largest sector due to the significant gap in relation to the second-largest one. The number of fallen angels is expected to increase, owing to – as mentioned earlier – an earnings decline on the back of the bleaker economic outlook and interest costs escalating due to higher interest rates and spreads.

Overall, we expect the market to be much less volatile in 2023 than in 2022. We would, however, expect greater disparity at the individual stock level, as the fundamental outlook for individual companies continues to diverge. Consequently, this makes security selection a more complex task. However, technical factors are likely to offer support. In the US in particular, the market is shrinking and therefore better able to cushion the impact of potential outflows. We nevertheless prefer euro high yield bonds, as – for the same rating – they offer investors a higher spread than their US peers (and all the more so the lower the rating). In addition, the euro high yield market is rather more defensive overall because of its higher average rating and lower duration.

In general we expect investors to return to the high yield market, which has been the subject of significant outflows over the past two years. With interest rates at a more ‘reasonable’ level, monetary policy should help the high yield market to gradually move away from the conditions of the last 15 years, and back to those seen before the global financial crisis, resulting in a positive performance this year.