Things may be looking up for high-yield bonds

Chart of the week

Euro denominated high-yield bonds are starting the new year on more solid footing than they ended in 2018.

2018 was a year to forget for many investors, including those in high-yield (HY) bonds. On both sides of the Atlantic, things went reasonably well for the first three quarters. In the last three months though, political uncertainty, tighter monetary policy and weaker corporate fundamentals , especially in some of Europe's bigger sectors, contributed to a strong and broad increase in risk aversion and financial-market volatility . Like their peers in equity markets, investors in high-yield bonds increasingly began to fret about growing recession risks.

With the benefit of hindsight, such fears are already starting to look a little overdone. Recent economic data points to continuing strong economic momentum in the United States. As a result, U.S. high-yield spreads have already tightened by 80 basis points (bps) since the beginning of the year. This shows how quickly prevailing market narratives can change.

Certainly, "there is no shortage in Europe of things that could go right," argues Per Wehrmann, Head of European High-Yield at DWS. This is not to deny that fundamental risk has increased. The default risk appears somewhat higher than in recent years, especially for issuers from structurally weak and cyclical sectors, such as retail, capital goods and construction, and from economically struggling countries, most notably the United Kingdom and Italy. Similar risks exist for issues with lower ratings and with material refinancing needs in the near future. Overall, however, default rates remain very low. "With still no recession in sight, we do not expect a sharp increase in default rates in the coming months, as the broad majority of issuers are fundamentally relatively solid and do not face short-term refinancing requirements," Per Wehrmann concludes. Our base case is that we would expect spreads to tighten over the next 12 months.

Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 1/10/19

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