Assuming the world does not slide into a severe global recession, said Brils, global high yield bonds (apart from the energy sector) currently represent an attractive investent proposition. If it manages to avoid defaults and minimise credit losses incurred, a strategy that focuses on higher quality segments such as the BB and B tiers should outperform the broader high yield market, in Brils view.
“Many defaults and credit losses can theoretically be avoided by excluding triple-C and lower rated bonds and focusing on the double-B and single-B rating tiers which are comparable in credit quality,” said Brils.
The outlook is based on the rough ride global high yield bonds have had in the past months with yield differentials relative to corresponding government bond yields having widened by more than 1%.
“Following an aggressive sell-off, high yield bonds appear to have largely priced in expectations of declining issuer credit quality and some risk of a recession,” explained Brils.
Moreover, Central Banks, and particularly the European Central Bank, are likely to provide ongoing support to markets which should underpin demand for high yield bonds, notes Brils.
But while the question has arisen as to whether high yield bonds are now becoming good value as spreads continue to widen, the asset class is still likely to remain sensitive to fluctuations in the oil price.
“There are currently many reports saying that default rates in high yield are set to rise. In our view, most of these defaults will occur in the energy sector, which is already trading at distressed levels. In other words, most of the losses in this sector have probably already occurred,” said Brils.
Meanwhile, defaults are currently at just below 2%, excluding commodities. In BMO’s view, default rates in high yield (excluding energy) will increase moderately to around 4%.
Other concerns include global growth and China, political uncertainty in Europe and the timeline of future US interest rate hikes, according to Brils.
However, the appeal of high yield bonds lies mainly in their relatively low sensitivity to changes in interest rates, as well as the income they generate. “From an asset allocation perspective, we continue to view the appeal of high yield bonds as lying predominantly in the income they generate and their relatively low interest rate sensitivity,” he concluded.
