Having spent two years worrying about inflation and interest rate risk, central banks finally began lowering their key interest rates in 2024. Lower short-term interest rates have pulled bond yields downwards in both Europe and the United States and are likely to drag them well below their 2022-2023 levels, albeit without placing them back in negative territory as was the case in the previous decade.

Such a major change in the interest rate environment requires some serious thinking about which investments to make or hold in this new cycle and about their relevance in terms of both returns and risk levels. Here we take a close look at high-yield bond investments, especially carry strategies such as target-date funds, in the light of this new market environment.

How do high-yield returns compare with government bond yields?

Returns offered in the high-yield market are still well above those offered by govies. If we take our portfolios as an example, they deliver gross returns in euros of around 5% for a maturity of 3 years (MAM Target 2027 fund) and around 6% for a maturity of 6 years (Mandarine Global Target 2030 fund). These yields still allow for an attractive carry trade, whether compared to short-term interest rates (3-month rate at 3.42%) or long-term interest rates (German 5-year rate at 2.02%). Such a carry trade delivers return in exchange for risk, of course; in this case, the main risk is that of one or more portfolio companies defaulting. The final performance of such strategies therefore depends on whether or not this risk materialises and on the investment team’s ability to minimise the impact on portfolio value.

Average coupon & yield on Euro (left) and US (right) high-yield bonds

Data as of 31/10/2024 l Sources: Mandarine Gestion, ICE BofA and Bloomberg

Yields are attractive, but what about the main risk which is that of the financial health of companies in the high-yield segment?

There are three indicators showing that their financial situation is improving. First of all, high-yield companies have raised over €110 billion in the primary market in 2024, more than double the amounts raised in 2023 and 2022. These bonds have been issued mainly to refinance existing debt, thus extending debt maturities from 3 to 5 years and reducing liquidity risk accordingly. And the average market coupon is converging towards the average yield, indicating that the market is finding its point of equilibrium at an interest rate of around 5%. This rate corresponds to the average interest expense and is perfectly manageable by companies; it is well below the level that the surge in interest rates in 2022 and early 2023 might have suggested (the rate was above the 8% mark at the end of 2022). Last of all, new issuers have been moving back into the primary euro-denominated high-yield market in 2024, especially new LBOs which is the riskiest segment in this market and also the most difficult to finance when markets are anxious. The fact that the market is again able to finance this segment is another indication that companies are in good health.

Where to allocate risk and which market segments to focus on?

The eurozone is flirting with a recession (as reflected in the German government’s forecasts for 2024), whereas the US economy is proving remarkably resilient. We have factored these underlying trends into the way we manage our portfolios and have adopted the following positions:
A cautious approach to eurozone companies by favouring the least risky high-yield companies (those in the BB segment) and by emphasising those sectors that are holding up against the slowdown (telecoms, financial services) as well as debt issued by property investment companies that are reaping the full benefits of lower interest rates.
More opportunistic investments in US companies that are rated in the B category (riskier than the BB category) in order to achieve attractive yields of between 6% and 9% (in dollars), with a preference for large, listed companies carrying liquid debt.
A play on British companies now that the economy’s fundamentals are returning to normal after having drifted post-Brexit, with the result that high-yield instruments in sterling offer far higher risk premiums than those on the euro-denominated market.
We believe these investment priorities will deliver attractive returns over the coming years, even as we face a future of lower interest rates and yield opportunities become increasingly scarce.

Does it still make sense to invest in high-yield bonds while interest rates are falling?

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