High-yield bonds are heading back to junk

Chart of european bond and dividend yields

“Equities are the new high yield,” says Ioannis Angelakis of Merrill Lynch. Yields on high-yield bonds (the riskier part of the debt market, often known as junk bonds) have fallen so far in Europe that they are lower than the dividend yield available on equities. And while US junk bond yields remain higher than dividend yields, the trend there has also been down. “Investors are getting the lowest yields on the riskiest bonds in almost three years, another sign of the high level of complacency in financial markets,” says Jeff Cox on CNBC.

Low default rates on junk bonds, coupled with low interest rates on both sides of the Atlantic, have attracted yield-hungry investors into riskier parts of the credit market. This has helped push up bonds prices and delivered stellar returns in recent years – but that’s unlikely to continue in future, Percival Stanion of fund manager Pictet tells Bloomberg. “This is an asset class we have loved for a number of years. Now you have to believe in a very benign outcome for government yields, default rates and recoveries. That is a foolish way to invest… Prices have become irrational.”

That’s because for several decades, “high-yield bonds have been one of the best-performing asset classes on a risk-adjusted basis of any in the world”, says Fraser Lundie of investment firm Hermes in the Financial Times. But “like all things too good to last, capital markets have come to chew the fat off this remarkable record”. Firms are increasingly issuing bonds that offer both far lower potential returns and far less protection for buyers. That bodes poorly once the credit cycle turns. “It is ironic that an asset class that has taken decades to rid itself of the unflattering ‘junk’ tag now finds itself in a state more likely to exhibit junk status than ever before.”