The fund selector’s view
Martin Ward, senior investment research analyst, Square Mile
Following two years of strong returns for global high-yield bond markets, investors like us are questioning whether this momentum can continue. On the one hand, credit spreads are tight, reflecting more expensive valuations. This limits the potential for further capital appreciation and makes the asset class vulnerable to spreads widening if we see bouts of volatility in 2025. Such volatility is plausible given ongoing uncertainties around global growth, the trajectory of interest rates, inflation and geopolitics.
However, one could argue that corporate fundamentals broadly appear robust and that there is a solid technical backdrop supporting the market. Additionally, starting all-in yields are attractive, offering strong income potential for clients. This income should also act as a buffer for returns if elevated levels of volatility arise from credit spread movements.
Managers are also observing increasing dispersion across the high-yield market, particularly between higher-quality companies and those with more stretched balance sheets. This underscores the importance of precise bottom-up credit selection in 2025 to mitigate the risk of capital erosion.
Our preferred choice in this space is the Aegon High Yield Bond fund, which currently has a bias toward higher-quality companies while being positioned to generate income and provide downside protection. Given the tight credit spreads and prevailing uncertainties, we believe this is a prudent approach. We also expect the managers to opportunistically capitalise on any volatility affecting corporate credit spreads. The distribution yield of 7.5% as at the end of 2024 is also a strong starting point, offering a high level of potential income.
At a headline level, we remain cautiously optimistic about returns in 2025, though they are unlikely to match the strength of 2024. Investors should prepare for potential credit spread volatility, with income expected to play a more significant role than capital appreciation in driving returns.
The portfolio manager’s view
Brent Olson and Thomas Ross, fixed income portfolio managers, Janus Henderson
High yield bonds motored along in 2024, benefiting from both their high income and a boost from credit spreads tightening, which had the effect of generating capital gains as it pulled yields lower. Recall that bond prices rise when yields fall and vice versa. We think 2025 should shape up to be another positive year for high yield, albeit with returns more likely to be driven by income as spread tightening fades and gives way to some widening.
With credit spreads towards the tight end of their range, it is becoming difficult for them to tighten much further.
Yields on high yields bonds are, however, close to the middle of where they have been trading over the past 20 years. With central banks likely to pursue further interest rate cuts in 2025, we think investors will continue to see attractions in high-yield bonds given average yields of 5.6% in Europe and 7.2% in the US.
There is some tension in the markets as we await the new Donald Trump administration and how quickly and to what extent policies are enacted. A difference to 2016 when Trump last became US president is that many high-yield bonds are trading below par value: on average 96 cents in the dollar. Much of this is a legacy effect from bonds being issued with coupons below today’s yields a few years ago. It does, however, offer a useful pull to par as the bond price rises as it gets closer to maturity.
Spreads are tight but it is not unusual for them to stay tight for long periods. This is because corporate conditions take time to change. Once they have been through a period of change they tend to settle at the extreme, ie spreads spike higher during a crisis and take some time to retreat while staying low during a period of economic stability.
The CIO’s view
Sebastiano Pirro, CIO, Algebris Investments
We suspect 2025 may be a tricky year for credit markets. In retrospect, 2022’s events created a one-off opportunity for the asset class. The combination of higher rates and wider spreads changed the yields’ landscape dramatically, and early buyers could lock in 9-12% all-in yield in high-yield markets.
Fast forward two years, and the trade has largely played out. In 2023, we saw a broad performance with quality bonds leading, and 2024 the final part of the credit cycle with high yield/low rated assets catching up and displaying strong performance – despite a mixed year for rates.
Post the big run, valuations are not compelling anymore, at least at asset class level. High-yield spreads are at five-year lows, and implied default rates are well below historical averages. Last year, there were few defaults and refinancing markets remained wide open, but the bar to outpace what is implicit in valuations is nonetheless high.
All-in yields remain high, thanks to the rates component. Carry is a double-edged sword, as it often attracts faster-moving capital at the end of the cycle, creating the potential for a fast exit should rates turn more volatile.
The search for carry is apparent in the recent outperformance of distressed indices: as investors look for yield, market dispersion has fallen fast.
Opportunities exist: in the subordinated corporate space, some issuers still pay 400-500 basis-point spreads, despite solid capital structures, particularly in financials and utilities. The real estate sector is also trading wide to index due to high interest rates. In telecommunications, some of the capital structure stands out as cheap. Other sectors are now trading too tight however, due to generalised spread tightening. For example, European autos are trading at all-time tight spreads despite falling revenues and slowly increasing leverage.
It will be difficult to make money in credit – and in high yield – by buying an index. But opportunities continue for the bond picker.
The wealth manager’s view
Will Dickson, CIO, P1 Investment Partners
High yield bonds performed well in 2024, as would be expected given rising equity markets, falling interest rates and robust economic growth in the US. However, credit spreads are now very tight, limiting the potential for further capital gains and increasing risks of weaker returns by widening spreads.
While narrow spreads can persist for prolonged periods (eg 2004-2007), sell-offs in the sector can be aggressive. Important to consider is that these periods of weakness for high-yield bonds often correlate with declines in equities. They are therefore not an attractive diversifier within a wider multi-asset portfolio.
With the prospect for capital gains limited, the potential return from these bonds is consequently capped at their current yield to maturity of around 6%. History suggests that the best returns from high-yield bonds come after periods of widening spreads, where running yields are higher and capital gains through spread tightening are more likely.
At the current time, the opportunity cost of waiting on the sidelines is low and the risk of short-term capital losses is correspondingly greater. Therefore, investors may find the defensiveness of better quality bonds, or the uncapped potential gains from equities more attractive options.
Within P1 portfolios, we retain limited exposure to high-yield bonds, preferring a barbell approach of better quality, shorter-dated fixed income – providing protection against market volatility –alongside an equity allocation skewed towards smaller companies – to benefit from rising risk assets.
This article first appeared in the January issue of Portfolio Adviser magazine