The market for high-yield corporate bonds has long ceased to be a niche segment. It has developed rapidly in recent decades, reaching a total volume of more than 350 billion EUR in Europe. High-yield bonds are used to finance companies from a broad spectrum of sectors ranging from industrial goods to services and healthcare. With more than 350 companies, the Euro high-yield market is also well diversified in terms of issuers.
In recent years, risky asset classes such as equities and high-yield corporate bonds have benefited from the long-term trend of falling interest rates. However, the rise in interest rates initiated by central banks to combat inflation has put an end to this for the time being. Investors have had to accept some losses this year regardless of credit rating. According to our analysis, with rising interest rates, bonds in the high-yield segment have now returned to potential attractive valuations. The asset class also offers advantages as a diversifying allocation in a portfolio.
POTENTIAL ATTRACTIVE RISK/RETURN PROFILE
High-yield bonds are generally considered by many investors as a risky asset class. But are they really as risky as equities, as is often assumed? The risk of an asset class can be measured by the fluctuation of its respective performance. In the medium to long term, volatility in the high-yield market is lower than in equities. One reason for this is that a company‘s high-yield bonds enjoy priority in its capital structure over equity capital.
High-yield bonds also tend to have shorter maturities and are therefore exposed to lower interest rate risk than investment-grade bonds. The current duration of the euro HY market (HEAE index) is around 3.2 compared with 4.8 for euro investment grade (ER00 index)1. Given the higher yields and shorter duration, Euro HY bonds provide a much larger buffer against rising yields according to our analysis.
LOW CORRELATION WITH OTHER ASSET CLASSES
Another not insignificant question is whether the addition of an asset class - in our case high-yield bonds - improves portfolio diversification. For this purpose, investors analyze the respective correlation with other asset classes, i.e. whether they develop more or less in tandem. High-yield bonds correlate to a lesser extent with equities, and the correlation with government bonds is even close to zero. This is because the yield on a highyield bond is essentially determined by the risk premium, which depends on the company's ability to service its debt and is not very sensitive to interest rate increases. According to us, therefore, an addition of high-yield bonds contributes demonstrably to the diversification of a multi-asset portfolio.
VARIOUS WAYS TO INTEGRATE HIGH YIELD IN PORTFOLIOS
Like equities, government and investment-grade corporate bonds, high-yield bonds are therefore a key asset class for investors. However, to optimize potential performance, a stringent investment approach based on the following pillars is crucial:
- Fundamental credit analysis to assess the quality of a company and its ability to service and repay debt
- A well-diversified portfolio of more than one hundred issuers spread across various business sectors
- A rigorous sell discipline policy to maintain a quality portfolio and anticipate any deterioration in the quality of the selected companies
There are several types of strategies for gaining exposure to the high-yield market: Those that follow the market benchmark with portfolios that have a duration slightly above 3 years, some others consisting in bonds with shorter maturities, which allows the construction of portfolios with a duration of less than 2 years. In addition to these traditional approaches, there are funds that offer a fixed maturity date. Compared to traditional high-yield structures, fixed-maturity funds offer the benefit of providing good visibility and a risk profile that reduces as maturity approaches.
According to our analysis, investing in a fixed-maturity fund allows you to replicate the behavior of a bond while benefiting from a high level of diversification as well as the resources provided by the management company to select quality issuers and to adjust positions if the situation of one or more companies deteriorates.
As a conclusion, high-yield bonds is a must-have asset class to hold in investors’ portfolios, just as equities, government bonds, and investment-grade corporate bonds. However it is important to remember that high-yield bonds asset class presents a risk of capital loss.
