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High-yield bonds – a look behind the scenes

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Author: Christin Bahr, Product Management Securities Erste Group

In the context of record lows of money market rates and low government bond yields, high-yield bonds remain in demand. In view of the already very low spreads it may be worthwhile having a closer look at this bond segment.

Ratings – what do they tell us?

 

Corporate bonds are rated by rating agencies such as Standard & Poors or Moody’s. The scale of rating classes ranges from AAA/Aaa (excellent) to D (default). High-yield bonds are bonds with ratings of BB, B, CCC, CC, and C. The investor assumes a higher default risk when investing in these bonds, but he/she receives a higher coupon/yield in return. Hence the term “high-yield bond”.

The historical default rates differ very much from each other, depending on the rating. For example, 15.1% of B-rated euro corporate bonds in the market index1 have defaulted in the past five years2, whereas only 5.7% of BB-rated bonds have defaulted.

1 BofAML Euro High Yield Index, as of 14 December 2017
2 Sources: ERSTE SPARINVEST on the basis of Deutsche Bank, S&P, Markit Group, default rates from each respective monetary union, cumulated over five years. As of 19 April 2017.

At the moment, the average annual yield to maturity of ESPA BOND EUROPE HIGH YIELD is  2.93%, and it is 6.48% for ESPA BOND USA HIGH YIELD.* Although at this point one has to deduct about 2% in costs for permanent hedging of the US dollar vis-à-vis the euro for ESPA BOND USA HIGH YIELD, this segment is still more attractive than its European peer.

*Data as of 29 December 2017. Source: Erste Asset Management

Europe: stronger ratings, higher weighting of the financial sector

The USD yield is currently beating its EUR counterpart; which is normal, since interest rates are higher in the US dollar region. But there is another reason for this difference, because the structure of the two high-yield markets bears significant differences. For example, the average rating of EUR high-yield bonds is BB, whereas that of USD high-yield bonds is only B. The average rating quality of USD high-yield bonds is also below that of their EUR peers. This is due to the sector allocation. In Europe, banks, telecoms, and utilities dominate the bond market, whereas in the USA the – in qualitative terms – weaker energy sector, industrials, and commodities play an important role.

What is the status quo?

Both in Europe and the USA, the economic upswing is intact. Profit margins have improved sustainably in particular among US companies, the most recent key balance sheet ratios are stable, and the levels of liquidity are sufficient3. According to IMF experts, the recently passed tax reform comes with a stimulating effect on the USA and its trading partners, at least temporarily.
3 Source: Erste Group Research, Global Strategy, January 2018

Default rates are at historically low levels, and the forecast by Moody’s dips even lower for the end of 2018.4
4Source: Moody’s Monthly Default Update: Global Corporate Default and Recovery Rates, as of November 2017

 

Historic annual default rates. Source: Moody’s Monthly Default Update: Global Corporate Default and Recovery Rates, as of November 2017

Diversification is key

By buying a high-yield bond, the investor assumes the default risk of an individual issuer. Spreading one’s capital across a larger number of companies is important in order to avoid cluster risks. At the moment, ESPA BOND USA HIGH YIELD contains 456 bonds, and ESPA BOND EUROPE HIGH YIELD holds 168 bonds. This means that the funds offer a broad degree of diversification also for small investment sums. The risk is spread across many issuers, and the attractive coupons are reflected in the regular dividends distributed by the funds.

High-yield bonds: pros and cons

Opportunities
  • Broad diversification across high-yield bonds
  • Sustainably attractive investment segment
  • Chance of high annual dividends
  • Currency hedging, therefore no currency effects
Risks
  • The share price of the fund may be subject to significant fluctuations
  • Price declines are possible particularly in the event of widening spreads (i.e. worsening ratings)
  • Average to low rating outside the investment grade segment, i.e. elevated risk of default
  • Capital loss is possible
Legal note:

Prognoses are no reliable indicator for future performance.

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Legal disclaimer

This document is an advertisement. All data is sourced from ERSTE-SPARINVEST Kapitalanlagegesellschaft m.b.H., Erste Asset Management GmbH and ERSTE Immobilien Kapitalanlagegesellschaft m.b.H. unless indicated otherwise. Our languages of communication are German and English.

The prospectus for UCITS (including any amendments) is published in Amtsblatt zur Wiener Zeitung in accordance with the provisions of the InvFG 2011 in the currently amended version. Information for Investors pursuant to § 21 AIFMG is prepared for the alternative investment funds (AIF) administered by ERSTE-SPARINVEST Kapitalanlagegesellschaft m.b.H., Erste Asset Management GmbH and for ERSTE Immobilien Kapitalanlagegesellschaft m.b.H. pursuant to the provisions of the AIFMG in connection with the InvFG 2011 and regarding ERSTE Immobilien Kapitalanlagegesellschaft m.b.H. published in Amtsblatt zur Wiener Zeitung or at the web site www.erste-am.com or www.ersteimmobilien.at .

The fund prospectus, Information for Investors pursuant to § 21 AIFMG and the key investor document/KID can be viewed in their latest versions at the web site www.erste-am.com or www.ersteimmobilien.at or obtained in their latest versions free of charge from the domicile of the management company and the domicile of the custodian bank. The exact date of the most recent publication of the fund prospectus, the languages in which the key investor document/KID is available, and any additional locations where the documents can be obtained can be viewed on the web site www.erste-am.com or www.ersteimmobilien.at .

This document serves as additional information for our investors and is based on the knowledge of the staff responsible for preparing it at the time of preparation. Our analyses and conclusions are general in nature and do not take into account the individual needs of our investors in terms of earnings, taxation and risk appetite. Past performance is not a reliable indicator of the future performance of a fund.

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