High Yield Bonds: Demystifying risk
to maximise returns

When building his portfolio, an investor seeks primarily to maximise returns while controlling the risks taken. The main way to do this is to diversify into asset classes with complementary risk/return profiles. Within the bond asset class, high-yield bonds, whether sovereign or corporate, are an attractive source of diversification. They offer a yield premium over investment-grade sovereign bonds, coupled with a decorrelation effect relative to the latter. However, in-depth analysis of issuers and selectivity are still required, as this extra yield goes hand in hand with a generally higher risk of default.

In a rather oversimplified way, we could say that defining the risk/return ratio is one of the cornerstones of successful asset management over the long term. Investors are constantly on the lookout for new sources of diversification to maximise their portfolio returns at a controlled level of risk.

Within the fixed-income universe, the high-yield sub-asset class is particularly attractive because, historically, it has allowed investors to generate higher risk-adjusted returns than other fixed-income assets. However, this higher return also comes with its share of additional risks that need to be taken into account in the portfolio analysis and construction process.

Characteristics and attractiveness of High Yield bonds

High Yield (HY) bonds are debt securities issued by issuers with a lower credit rating (BB+ and below) than Investment Grade (IG) issuers. This lower credit rating reflects the riskier nature of these issuers, particularly in terms of default risk, i.e. the probability that the issuer will be unable to repay the investor once the bond reaches maturity. This higher level of risk is therefore rewarded by a higher interest rate, which helps to attract investors looking for yield, especially in a low interest rate environment.

Evolution of HY and IG debt yields (January 2015 to July 2024)

Source: Bloomberg

This specific yield profile gives High Yield bonds a key role to play when it comes to diversifying a bond portfolio. Not only does the inclusion of these bonds increase portfolio yields, they also offer an attractive decorrelation potential compared with investment-grade sovereign bonds - considered a safe haven - in the event of economic instability. This decorrelation can help to reduce the overall volatility of a bond portfolio, thereby improving its risk-adjusted return profile.

The table below shows the correlations between different types of bonds over the last 5 years.¹

Correlation coefficients between bond asset classes

Source: Bloomberg

This low correlation is mainly explained by two factors: High Yield issues with traditionally shorter maturities and the higher interest rates they pay.

Make sure you're selective!

To maximise the opportunities offered by High Yield debt, while ensuring that we avoid exposure to issuers with unacceptably high risk profiles, we believe it is essential to adopt an active and selective approach to this asset class.

The HY bond universe covers the spectrum of both sovereign and corporate issuers, but each of these segments requires a specific analysis process that incorporates the specific characteristics of these two types of issuer.

Sovereign issuers

Among the different categories of HY sovereign issuers, we believe that those rated BB and B offer the most attractive profile. This is because their credit ratings, which are mainly from emerging countries, are usually limited by structural factors such as their small size or less diversified economies, whereas in periods of economic stability, these countries see their growth fuelled by consumption in developed countries.

In this context, an individual analysis of each issuer enables us to understand the dynamics at work. To this end, our research combines a macroeconomic analysis with an idiosyncratic analysis of each country, enabling us to take a prudent, risk-aware approach to these issuers.

Macroeconomic analysis ('top down') involves examining economic cycles to identify trends in risk-free rates (rates linked to developed economies such as Germany or the United States), enabling us to define our target duration (i.e. the interest-rate sensitivity of our investments).

As part of our 'bottom-up' analysis, we look at the specific features of each country, with the aim of identifying economies with improving fundamentals, and with governance focused on social development and promoting projects to diversify the country's exports. By analysing factors such as debt to GDP, banking system stability, economic complexity and governance, we are able to assess the sensitivity of these issuers to global shocks.

Overall, HY issuers are more sensitive to disruptions of various kinds and can find themselves in default quickly. However, some issuers whose fundamentals are improving are resilient in times of instability and have the capacity to build up reserves when the economy is prospering.

This is particularly the case for Costa Rica, rated BB, with inflation contained by its central bank and debt to GDP falling to around 60%. All of this against a background of reforms aimed at reducing unemployment through the building of infrastructure that will enable the economy to become more service-based, particularly in the information technology and communication services sectors. The country's resilience has enabled it to navigate the recent health crisis while benefiting from the economic recovery that followed. From a bond investment point of view, this has proved to be a rewarding investment.  

Corporate issuers

Indebtedness is certainly one of the factors taken into account when categorising a company in the High Yield segment, but it is not the only criterion. Other factors also come into play, such as the cyclicality of the company, its size or the diversification of its business. It is not uncommon for a company with low debt to be classified as high yield because, for example, it operates in cyclical markets or is in a growth phase.

At BLI, in parallel to the valuation criterion, the solvency factor and, by extension, the level of debt, is of paramount importance to us. In fact, within the HY segment, companies with controlled debt levels are our preferred investment targets, as they are best positioned to withstand adverse economic cycles and protect the interests of bondholders. So, despite a higher perceived risk because of the HY classification, by investing in companies with healthy balance sheets and solid fundamentals, we are able to minimise the risk of default and maximise returns for our investors.

Unlike the analysis of sovereign issuers, which takes macroeconomic factors into account, our approach to corporate issuers is purely bottom-up. To identify issuers with attractive valuations and solid solvability profiles, we analyse a number of financial indicators such as profitability, interest cover, gearing and liquidity. The aim is to identify solid companies that show a consistent ability to generate sufficient cash flow to cover their liabilities, which are kept under control.

For example, a company like Volvo Cars fits into our High Yield selection criteria. In recent years, it has shown discipline in managing its debt. Since 2015, despite the cyclical nature of its business, it has had a cash surplus in relation to its debt, enabling it to maintain a liquidity cushion in the event of an economic slowdown. The annual figures for 2023⁶ show that gross operating profit covers 52 times the total interest expense, whereas the median of this ratio for European cyclical high-yield companies is just 5 times. Considering these and other factors, the risk of default on Volvo Cars' bond issues over an investment horizon of less than 5 years seems low.

Conclusion

Historically, over the long term, among all bond assets, High Yield issues have shown the best performance in terms of volatility⁷, making this asset class a prime diversification tool in the portfolio construction process. However, the increased risks associated with this asset class should not be overlooked. An active, cautious and disciplined approach is essential, in particular by favouring issuers in this segment that have their debt levels under control and are capable of withstanding temporary headwinds.

¹ Period from 16/07/2019 to 16/07/2024 - Euro-denominated bond

² JP Morgan EMU AAA-AA Index

³ ICE BofA Euro Corporate Index

⁴ ICE BofA Euro BB-B High Yield Index

⁵ JP Morgan Euro Emerging Markets High Yield Index

⁶ Source: Bloomberg, Financial Analysis.

⁷ Over a 5 and 10 year period for the 4 market indices presented in the previous table.

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Date of publication: 28 August 2024

Time of publication: 11:30

Authors:

Maxime Smekens, Co-Fund Manager, info@blu.lu

Jean-Albert Carnevali, Fund Manager, info@bli.lu

The authors of this document are employed by BLI - Banque de Luxembourg Investments, a management company approved by the Commission de Surveillance du Secteur Financier (CCSF) in Luxembourg.