Risk-conscious high-yield management fits the current market environment

Typically, high-yield investors lose out during periods of tight lending standards, low investor risk appetite and below-average macroeconomic performance, but this has not been the case in recent years. Since 2021, high-yield corporate bonds have outperformed their investment-grade counterparts in absolute terms. For high yield, this means that there is room to question whether they are still attractive.

There are several factors behind the strong performance of high yield bonds. In times of crisis, the general level of interest rates on credit risk-free government bonds usually falls and government bond prices rise, but the opposite has been the case over the past three and a half years. Starting from a very low interest rate level, the rise in inflation in 2021, exacerbated by a supply shock from the Ukraine-Russia war in 2022, led to very large losses even for perceived safe government bonds. Although high-yield bonds also suffered from the repricing of credit risks, losses remained below investment grade levels even in the crisis year of 2022 due to the shorter average duration. In 2023, and also since the beginning of the year, high yield has benefited from the significant rise in yield levels and narrowing spreads. This is reflected in a strong performance (+13.4% for 2023 and +3.1% for USD high yield in the first half of 2024).

The flip side of the coin is that spreads are currently at below-average levels, as shown in Figure 2. Looking at spread history since January 2000, risk premia on USD high yield bonds have been below current levels in only 14 % of all months (end July 2024). In the euro area, credit risks have been priced below current levels 36 % of the time.

Credit standards tighten, but debt ratios have improved

A second issue affecting the attractiveness of high yield is the tightening of bank lending. A look at the correlation between lending standards and default rates shows that, empirically, more restrictive bank lending leads to higher default rates in the high-yield bond market. In the 2008/2009 financial crisis, lending standards were tightened dramatically, resulting in default rates of 16 %. Banks have also been less willing to lend to weak companies in recent months, partly due to tighter monetary policy.

At around 5 %, default rates are now close to historical averages, while lending is being tightened. Can we therefore expect higher default rates in the coming quarters, leading to rising risk premiums and thus negative performance in the high-yield segment?

There are currently many indications that we are not in a ‘normal’ economic cycle. The last severe recession was only just behind us in 2020, and we have not seen a boom phase since then. Due to inflation and geopolitical concerns as well as high interest rates, there is no typical exaggeration phase between two economic cycles, and in such boom phases companies tend to build up debt due to high CAPEX and spending on company takeovers. Instead, companies have reduced debt in recent years, as Figure 4 shows. At their peak in 2021, high-yield companies had debt equivalent to 17 times EBITDA. Since then, debt has been reduced so that we are currently in the range of the long-term average of 12x EBITDA. Despite the tightening of credit standards, the improved debt to EBITDA ratio indicates that defaults may remain low.

Corporate defaults less likely due to lower unemployment and fiscal support

Another indication that we are not in a “normal” credit cycle is provided by a look at US public finances.

Empirically, there is a clear correlation between the level of unemployment and the general government budget balance. In periods of high unemployment, the budget deficit tends to be high due to lower tax revenues and increased support measures; in periods of low unemployment, the budget deficit tends to fall, and in periods of economic expansion, the budget deficit tends to be in surplus.

In 2020 and 2021, US unemployment peaked at just over 8% and the corresponding deficit reached its highest level since the data series began in 1967 (Figure 5). While unemployment has fallen to below average levels in recent years, fiscal support has remained high. Fiscal spending can be expected to remain high regardless of the outcome of the US elections. This also supports the private sector, making high-yield defaults less likely. In the absence of another exogenous shock, a sharp rise in high-yield corporate default rates is therefore unlikely.

BB+ yields stand out as attractive

High yield bonds continue to offer significantly higher yields than investment-grade bonds. When comparing the rating classes, the best segment BB+ stands out in particular. A strong yield premium over BBB- can be observed here. The best quality high-yield rating segment benefits from technical factors such as the Fallen Angel effect, which leads to selling pressure on downgraded issuers and therefore offers attractive opportunities for risk-taking investors. At the same time, the risks of BB+ bonds are lower than those of lower-rated bonds, making them an interesting option for yield-oriented investors.

Summary

Anyone considering whether high yield is currently the right asset class in view of the unclear economic picture and low spread levels, but at the same time finds the current yield levels and high carry attractive, has the opportunity to integrate high yield into their portfolio in a risk-reduced manner. Our High Yield MinRisk approach targets this “sweet spot” in the high yield market and also systematically reduces concentration risks. By increasing diversification compared to the market index, we avoid high risks from individual issuers and sectors. The strategy is geared towards maximising the Sharpe ratio and aims to achieve a risk-adjusted performance independent of a benchmark. The suffix “MinRisk” stands for strict risk management that is independent of index characteristics and a high level of diversification across several risk dimensions.