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April 1, 2014

Why High-Yield Bonds should no longer be on your buy-list

It is time to say good-bye to one of the best performing asset-classes since 2009. European High-Yield Bonds generated a total return of 150% or approx. 20% p.a. since the low of the financial crisis. However, based on today’s valuation, we expect medium-to-long-term returns to be only around 2%-3% p.a.

High Yield Index Total Return

1. Current yields have dropped to only 4%

As a result of the recent strong price increase, the yield of the European High-Yield index is now only 4%. It is simply mathematically impossible to get returns anywhere close to what we have seen in the last few years.

High Yield Index YTW

2. 4% still sounds too good to be true

At a time, when German 5y Bunds yield less than 1%, 4% may still sound attractive to some buyers. However, investors will not realize 4% returns but rather 3% or even less. High Yield bonds have a higher default risk than investment grade corporate bonds and the index returns need to be adjusted for that. At the moment, the default rate is very low, with the two largest rating agencies, Moodys and Standard & Poor’s, estimating a default rate for European High-Yield bonds below 1% for 2014. But those ultra-low default rates are due to the recovering economy and prevailing low-interest rates. Historically, the default rate was 2.0% (median) to 5.6% (mean). A fair assumption across the cycle is probably somewhere around 2.0%-2.5% p.a. The recovery rate is around 50%. Last but not least, investors might also be well advised to take the risk of rising rates into account as long-bond yields are likely to rise once central banks are running a less accomodative monetary policy.

Table 1Expected returns before costs
Index return per year+4.0%
Default rate-2.0%
Recovery rate+50%
Interest rate sensitivity-0.1%

3. … and finally the real return after costs

Since most investors won’t be buying High-Yield bonds directly, but via actively managed funds or index ETF, we still need to adjust for the costs of these investment vehicles.

Table 2Expected returns after costs
Return after costs+2.9%
Annual ETF fee-0.5%
Spread for buying-0.1%
Spread for selling-0.1%
Net result+2.2%

To be clear: we are big fans of High-Yield as an asset class. However, success in investing is not a function of what you buy. It is a function of what you pay. Right now, the price is not attractive anymore in our opinion.

Why are High-Yield bonds rather Low-Yield bonds, despite the high risk? The low interest rates of the US and European central banks have forced investors out on the risk curve in order to reach for yield, thereby driving up prices for all financial assets. But we have now reached a point, where the returns are increasingly disconnected from fundamentals. The following chart from Citi shows how spreads no longer follow leverage for US High-Yield bonds (same for EU bonds).

Citi Spreads no longer follow leverage

Does our cautious stance imply we are forecasting a crash in the High-Yield bond market? No, a real crash like 2008 requires a recession and this is not our central scenario for the US and for Europe in 2014. What we are saying is that 2%-3% annual returns are not enough compensation for a risky asset-class like sub-investment-grade High-Yield bonds.

The author worked more than 6 years on the High-Yield desk of one of the leading new issue banks in London.

For further questions, please contact us at info@ipanema-capital.com

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