BB-rated high-yield bonds offer higher interest rates with slightly higher risk. Higher-yield euro bonds with their risk-return ratio are currently a particularly attractive choice.
The returns and risk premiums on high-yield (HY) bonds with ratings below investment grade have risen to an above-average level since the beginning of 2022. Currently, high-yield bonds are trading at returns of 8.5% (USD HY) and 7.2% (EUR HY). The main trigger for this development is the central banks’ attempt to curb inflation – triggered by the pandemic and the war in Ukraine – with higher interest rates. The combination of inflation, rising interest rates and the resulting slowdown in economic growth is creating uncertainty and thus volatile risk premiums on the credit market.
In this context, credit investors fear a weakening of key credit figures and free cash flow, especially in the case of, for example, highly indebted and cyclical companies with a significant proportion of variable interest payment obligations. This can lead to rating downgrades and difficulties in refinancing, including defaults. Therefore, against the backdrop of the rise in yields but also the priced-in risk for investors, the question arises as to which segment should be preferred for HY bonds.
BB ratings and USD with the highest proportion of high-yield bonds in developed markets
In developed markets, the USD and EUR high yield bond segments combined now represent a nominal value of USD 1.8 trillion. The HY bond market increased significantly, particularly in the period after 2009, with an average annual growth rate of 4% (USD) and 10% (EUR). In the USA it is currently about three times as big as in Europe.
The ratings of high-yield bonds are divided into BB, B and CCC categories. HY bonds with a BB rating (BBs) represent the strongest and those with CCCs the weakest rating area. BBs make up the main share of the HY indices with around 70% in euros and around 50% in USD. This shows that Bs and CCCs have a greater weighting in USD than in euros.
Issuers of BB-rated bonds mainly fall into the following groups:
- “Falling angels,” i.e. companies that used to have an investment grade rating and could return to investment grade as “rising stars”
- Issuers that see a BB rating as their optimal leverage according to their financial policy
- Subordinated HY bonds issued by corporates or banks/insurers that have an investment grade rating
- Companies that are owned by private equity investors after a leveraged buyout (LBO) and therefore have a higher leverage ratio
Many European and American issuers issue their high-yield bonds in both USD and euros. For example, 9% of EUR-HY bonds were issued by North American issuers and 9% of USD-HY bonds were issued by non-North American issuers. The largest sectors for EUR-BBs are banks and the automotive industry at 15% and 13% respectively, while for USD-BBs it is energy at 15%, mainly oil and gas.
BBs in euros with a higher risk premium with moderate default rates
Due to the increased uncertainties on the credit market, the prospect of a further increase in default rates and the volatility of interest rates and credit risk premiums (spreads), the relatively secure BBs in euros are preferable for high-yield bonds. The current yield of BBs is 6.9% in USD and 6.2% in EUR. After deducting the expected annual loss (average default rate for BBs of approx. 1% and taking into account an average insolvency recovery rate of around 40%), this still results in an attractive net return even in scenarios with a weaker economic outlook. We currently prefer BBs in EUR mainly because their credit risk premium (in contrast to goverment bonds) is 3.4%, which is 0.7% higher than USD BBs. The interest rate risk (duration) of BBs is also slightly higher in USD than in EUR, which also speaks in favour of Euro-BBs in the current cycle of interest rate hikes. They also benefit from the fact that their annual total returns have been even higher than for Euro-BBBs over the past eleven out of thirteen years.