High yield bonds regain their shine

Equity markets have welcomed the Federal Reserve’s September interest rate cut and China’s stimulus package. The S&P 500 index has gained 20% year-to-date and Chinese equity indices have advanced as much in one month. But while stocks have gained ground, the relative attractiveness of high yield bonds has also risen. We examine the current risk-reward profile across assets.

As the final quarter of the year begins, the global landscape remains supportive for financial assets. We still expect the US to pull off an economic soft landing in 2025. Real US gross domestic product (GDP) should grow by 2% next year, with the European Union, Switzerland, UK and Japan recording growth of between 1% to 1.5%, and China and India expanding by 4.5% and 6.5% respectively. Central banks are likely to continue easing monetary conditions next year. The latest consumer price index (CPI) data in Europe were below market expectations, leaving room for faster rate cuts by the European Central Bank (ECB).

This offers a solid environment for risk assets. Historically, stocks gain by an average of 20% in the 12 months following a first Fed interest rate cut, as long as a recession can be avoided. In addition, in the year following US presidential elections, equity markets tend to perform well, regardless of who sits in the White House. In general, the candidate’s campaign programme is implemented in the first year, and provides a boost to markets.

In the year following US presidential elections, equity markets tend to perform well, regardless of who sits in the White House

But how are investors currently compensated for the risks they take across different financial assets? In the US, equity earnings yields are at about 3.7%, below 10-year US government bond yields and investment grade bond yields of around 5%. Significantly, current earnings yields are also below those of high yield bonds, where average yields are around 7%. The US equity risk premium (the spread between the earnings yield and government bond yields) is therefore close to zero¹.

The situation in Europe and Switzerland is different. Here, equity earnings yields are 7% and 5% respectively, contrasting with aggregate government bond yields of 4% and 0.40% respectively. The equity risk premium therefore remains positive at 3%, around its average in Europe, and an above average 4.6% in Switzerland.

At a global level, high yield bonds currently offer the highest yields across asset classes. In comparison, equities provide roughly the same yield as investment grade corporate bonds. Government bond yields provide the least risk among these financial assets, with the trade-off that they deliver lower yields.

At a global level, high yield bonds currently offer the highest yields across asset classes

High yield, deep dive

Of course, investors in high yield bonds must be mindful of default risks in a slowing global economy. A low projected level of defaults is one reason why the asset class currently trades at historically narrow spreads over less risky bonds. Moody’s estimates average default probabilities for 2025 at 2.9% for the high-yield segment globally, a relatively low baseline for the start of a rate cutting cycle. However, even if default risks do rise, current yields look high enough to absorb moderate credit spread widening without destroying the carry advantage for investors.

US high yield bond indices also have a high large share of energy sector issuers that may benefit from higher oil prices, perhaps driven by geopolitical shocks. A second Trump administration may offer additional support for US high yield bonds. Their relatively short duration, of 3.5 years on average, ensures limited interest rate sensitivity if investors start becoming concerned about inflation again. That may happen if a Republican White House raises import tariffs, or tightens immigration policy and so inflates US wages. If on the other hand 2025 brings a Harris presidency, the S&P 500 index’s 31% exposure to technology names, compared with 7% of the high yield index, would limit credit’s attractiveness compared with stocks.

A second Trump administration may offer additional support for US high yield bonds

Europe’s high yield opportunities

In Europe, average high-yield spreads are wider than in the US, for several reasons. Firstly, investors in European financial institutions demand higher compensation for perceived risks than in the US. Secondly, the energy sector, where spreads are lower, accounts for a larger share of the US high yield universe. Finally, Germany’s stalling car industry and worries over French public finances have also widened spreads compared to the US. These wider spreads create opportunities.

For euro-based investors, high yield corporate bonds outperform stocks, and both offer a better risk-reward profile than investment grade and government bonds. For Swiss franc-based investors, Swiss real estate and stocks outperform Swiss sovereign bonds and investment grade credit.

After particularly high returns from equities so far in 2024, corporate bonds remain a useful portfolio tool. They have also started to add diversification benefits, with correlations between equities and bonds falling to more typical levels. We currently hold both equities and overall fixed income allocations – both investment grade and high yield bonds – at strategic weights in portfolios. This remains a fast-evolving landscape for investment risk and returns with the US election just weeks away.