High yield bonds continue to offer attractive return potential for 2025

The global high yield bond market is on track for a strong 2024 performance of over 9% in US dollar terms and just under 8% in euro terms (hedged) after eleven months. Assuming no hiccups, it will have finished 12 out of the last 15 years with a total return gain. This provides a sense of the stability and resilience of the asset class. Given our macroeconomic view of solid growth, in particular in the US, and supportive central banks, we believe that a globally diversified portfolio of high yield bonds offers the potential for attractive returns in 2025 as well.

Issuer fundamentals in the global high yield universe remain in good shape. The most relevant companies in Europe and the US on average have leverage ratios (as measured by net debt/EBITDA) of around 4x. Interest coverage ratios (EBITDA/interest expenses) have declined a bit, reflecting the increase in financing costs over the last two years but are still at around 4-4.5x, comfortably above the long-term averages (source: Bank of America). Digging deeper into sector levels, there are obviously different developments – difficulties in the auto sector, for example, in contrast to the prospering leisure/travel companies. However, in aggregate the companies are in good shape.

These comparably sound balance sheets are also reflected in the default rate. For the last 12 months it is estimated to be ca. 1.4% in US HY and 2.8% in EUR HY (source: BofA). This is below the long-term average of 4%. Importantly, this already benign number is expected to drop even further in 2025. A good early indicator for future default rates is the amount of bonds trading at distressed levels. This is defined as bonds trading at a spread of at least 1000 bps above the comparable government bond. Currently the amount of distressed bonds in the global index is low at less than 3%.

Technicals are also supportive. The size of the global high yield market has been shrinking over the last 2 years, mainly due to Rising Stars leaving the high yield market and moving into the investment grade segment as a result of ratings upgrades. The number of new entrants, however, has been smaller, given the lack of Fallen Angels and the scarcity of LBO activity due to the relatively high financing costs. On the other hand, fund flows into the asset class, an estimate for allocators’ interest in the asset class, are currently strong after weaker years from 2022-2023, reflecting the positive environment for high yield. As a result, the supply/demand picture is supportive for bond prices.

Valuations reflect the relatively sound fundamentals and supportive technical factors. Spreads over government bonds have reached ambitious levels. Valuations are similarly demanding as in equities or other credit areas, such as investment grade. However, there are a few factors to consider, which show that spreads in the historical context are not as tight as they appear. Over recent years, the quality of the high yield market as measured by ratings has improved. For instance, the portion of the highest rating category, BB-rated bonds, is 60% today, while it was just 40% back in 2007. On the flipside, the portion of the riskiest category, the CCCs, was 16% back then and stands at 9.5% today. In addition, the duration of the global high yield market has shortened significantly over recent years. Today, the effective duration is 3.2 years, while it was 4.0 years in 2021. Adjusted for the shorter duration, spreads are in a similar context as they were for long periods in recent years. In our view, the spreads are therefore not as expensive as they appear at first glance, as the broad market is less risky today and they also reflect the stable fundamentals.

We expect the drivers of a strong 2024 to carry over into 2025, which should allow for returns close to the current market yield of 7%. While we do not expect a recession, certain risks could arise, in particular political intervention affecting certain sectors and/or geopolitical tensions. Given the still relatively high rates, central banks are well equipped to support the economies globally.