What is the outlook for high yield and emerging market bonds?, April 2023

After posting the weakest year on record, bond markets have started 2023 more strongly, buoyed by receding recession probabilities and the hope that inflation has started to peak across the developed world.

There has been much talk about the opportunities in US and UK government bonds, as well as investment grade bonds. But what of the higher risk areas of high yield bonds and emerging market debt?

New era for financial markets?

Over the past decade, both high yield and emerging market debt have been the place to be for income investors, as developed market investment grade and government bonds offered little to no yield. In some cases – such as German government bonds – the yield even turned negative at one point, leading investors to pay for the privilege of owning them!

However, as we move into a new ear for financial markets - now interest rates have risen substantially across developed markets - both emerging market bonds and high yield face stiffer competition and are more at risk of default if economies slow significantly.

“Unlike the last decade it really will matter who you lend money to, said Kelly Prior, Investment Manager in the team that runs the CT MM Navigator Distribution fund at Columbia Threadneedle Investments. 

Kelly believes there will be more pronounced differences that the more decerning investor can take advantage of “as the cost of capital rises for high yield companies, and central bankers tackle varying inflation rates in emerging markets.”

The outlook for high yield bonds

Just as mortgage rates have increased for homeowners, so too has the cost of loans for companies – as interest rates have increased, bond holders are demanding higher rates of income. But this can vary by region, creating opportunities.
“US corporates must refinance maturing debt at a much higher all-in yield relative to their European counterparts, owing to the higher base rates in the US,” commented Alexander Pelteshki, co-manager of the Aegon Strategic Bond fund. 

Alexander also believes that the risks of a major economic slowdown have rapidly turned in favour of the US and that from a valuation perspective European high yield is far more attractive.

Will defaults rise?

Alexander says that “We are emerging from historic lows in corporate defaults (2.8% in 2022), and we expect that rate to increase in 2023 as higher funding costs impair the ability of some operators to roll over maturing debt. Moody’s expects speculative-grade corporate defaults in 2023 to increase to 5.1% in its baseline scenario.”

The team behind the TwentyFour Dynamic Bond fund, however, argue that the number of upgrades started outpacing downgrades in the high yield bond sector in January. “Granted, this is just one month of data, but it does emphasise the strength of the fundamentals within the high yield market and how rating agencies are still looking favourably at companies, particularly as the macroeconomic backdrop is potentially becoming more supportive than we expected only a few months ago,” it stated. 

Capital Group’s Chris Miles is less concerned about both recession and default rates in the US and thinks the US high yield market is potentially a good place to be as “They are entering a probable recession from a position of strength.”

“Having issued a significant amount of debt at very low levels of yields with longer maturities in the last couple of years since the Covid crisis, their low refinancing needs reduces default risk in the short term,” he said.

“Today, more than 50 percent of the US High yield market is rated double B, and usually that cohort tends to have a very low default risk. The high yield market is more resilient than before, and while spreads have compressed significantly over the last few months, the overall yield still represents an attractive total return opportunity.”

“The credit quality of the high yield market has improved considerably over the past 15 years, and it is worth noting that mild recessions have not necessarily been bad environments for the asset class in the past,” added the Barings high yield bond team.

“The risk-reward picture remains compelling, particularly in higher-rated parts of the bond and loan universe. With high yield bonds trading with a roughly 10-15% discount to par, this provides some cushion against possible credit losses and reflects the potential for strong capital appreciation.”

What about emerging markets?

The Barings team says that 2023 is shaping up to be a promising year for the asset class, “Especially given that inflation has started reacting to monetary tightening, geopolitical fogs around the world are dissipating, China’s economy has re-opened, and there is a potential central bank policy pivot in the card,” it said. “This is supportive of both emerging market sovereigns and corporates, but we see benefits to staying up in quality and focusing on issuers that can withstand further uncertainty.”

The outlook for emerging market debt returns in 2023 is mostly positive given the more attractive starting yields in many areas of the market compared to the post-covid period,” agreed Chris Miles.

“It is reasonable to expect significantly better return outcomes across both hard currency and local currency in 2023 compared to 2022 in the absence of a deep global recession and a crisis in a major emerging market country,” he added. “On the back of improved valuations, and a reopening of China, that could provide support for emerging market countries through stronger domestic economic growth, consumption and investment.”

While not always positive about the prospects for his own asset class, Richard House, head of emerging market debt at Allianz is also bullish on it today. At an event last week, he pointed out that historically, when the US Federal Reserve stops raising interest rates, emerging market debt has been the best performing asset class.

He also said that with emerging market growth stronger than that in developed markets, emerging market economies having raise their rates earlier and valuations looking reasonable, there are plenty of opportunities to be found.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and should not be taken as investment advice.