When high-yield bond markets took off 35 years ago, a market period of persistently low inflation began. Over the past two decades, inflation has been subdued and interest rates have remained well below the levels of the second half of the 20th century. High yield bonds developed in calm waters.
By contrast, high-yield bonds were born during the period of unusually high inflation in the 1970s and early 1980s. In the United States, the high-yield bond market boomed in the mid-1980s, helping in part to finance leveraged buyouts aimed at investing underutilized corporate assets. Europe followed suit about a decade later.
So with the return to higher inflation and higher interest rates, it’s fair to say that high-yield bond markets are entering uncharted territory (Figure 1); an environment where we believe that particularly careful bond selection is becoming increasingly important.
The roughly 15 years since the global financial crisis have been marked by quantitative easing and extraordinary monetary conditions designed specifically to support companies financially. Interest rates are at historically low levels – especially in contrast to the inflationary era of the 1970s and 1980s. While the Federal Reserve tried to end the easy money era in 2013 and then in 2019, negative reactions in the financial markets prevented them from doing so.
Figure 1: An inflationary environment – for the first time in a long time
But this year central banks have had no choice but to raise interest rates as inflation topped 10% in the euro area and 8% in the US – well above the false 2%. As government bond yields also rise across the yield curve and corporate interest rate spreads widen, the inevitable result is that corporate financing costs rise to levels not seen for many years.
Rising interest rates put weaker companies under pressure
For leveraged high-yield issuers, the higher cost of servicing debt inevitably affects cash flow and earnings. Some will generate lower profits and reduce their dividend payouts; others may struggle to survive. We expect the weakest credits – rated CCC – to come under more pressure. The risk of default has increased compared to the past 15 years, which were characterized by favorable financing conditions.
The pressure on businesses is likely to increase further if the current high level of inflation continues. The background: Many of the inflation factors are beyond the central banks’ control. An increase in interest rates does little to solve problems such as logistical bottlenecks, shortages of raw materials and labor shortages that are evident in many countries.
From a fund management perspective, understanding which companies can thrive in this tougher environment is crucial. Some companies are in a powerful position: they make exceptional products and can control their prices. However, such robust companies are more likely to be found among investment grade issuers.
However, the current environment can be particularly challenging for the private equity firms that form part of the high yield universe. An increase in the so-called risk-free interest rates – the interest rates on government bonds – increases the discount rate used to value shares in public markets. As a result, stock valuations, such as price-to-earnings (P/E) ratios, fall. For example, the US market-wide index S&P 500 currently trades at 20 times earnings (based on reported 2021 earnings), down from 25 a year ago, while the technology-heavy US index Nasdaq fell to 25 from 31 a year ago ( and tied of 20 in May 2022).
Surprisingly, in 2022 there was little difference in the performance of bonds with different credit ratings. However, we do not believe that this situation will continue: The weaker companies are struggling with rising interest rates and should therefore trade with a higher risk premium.
Another challenge for high-performing companies is the ongoing energy crisis and energy transition. They make energy more expensive and put additional pressure on companies in all sectors (figure 2). In such an environment, we traditionally prefer stable sectors such as telecommunications on the one hand, and companies with solid backlogs and good credit ratings on the other, such as car manufacturers, on the other.
Figure 2: All sectors under pressure
Stock picking becomes more important
In 2022, the cautious positioning in our portfolios has not paid off so far. Nevertheless, in these unprecedented times for high-yield bonds, in-depth analysis is essential. Our team and the investment process they represent have weathered a number of difficult credit cycles. We continue to look for high quality companies that can weather this difficult market period well.
Today’s high and rising interest rates are unprecedented for high-yield bonds, but at the end of the day, all crises are special in their own way: for example, the financial turmoil triggered by the pandemic was as special as the financial crisis of 2008 and 2009.
Fund management is always about using intensive research to find the companies that can navigate difficult waters. At some point, inflation and interest rates will fall again and the situation will calm down – at least for those who have navigated well.