One man’s loss…

High inflation and rapid rate hikes by many central banks resulted in some of the strongest and fastest price declines ever seen on the bond markets in 2021/2022. For riskier issuers (Emerging Markets, euro periphery countries, corporate bonds), the increase in yields was also accompanied by widening yield premiums. For existing investors, the massive price declines are painful. Depending on how long these investors hold the bonds and in which bonds they are invested, the returns from recent years have more or less already been eaten up by the price reductions.

… is another man’s gain

That said, strong increases in yields also have a (very) positive flip side: Anyone who purchases bonds right now receives yields that have not been seen for quite some time, at least not in nominal terms. Looking at real returns, however, which take into account inflation, this is only partially true. In nominal terms, German government bonds (basically the “gold standard” in the euro area) are yielding 2.6% to 3.3%, the highest level in more than ten years.

Corporate bonds: higher returns, but also higher risk

Corporate bonds offer even better returns, as these instruments also feature yield premiums (as compensation for higher default risks, lower liquidity, etc.). Thus, returns of around 4.5% p.a. can be earned on high-quality corporate bonds (investment grade, or IG) depending on the maturity (provided that payments occur regularly and completely). For high yield bonds, returns of 7% p.a. and more are even possible, albeit in conjunction with a significantly higher risk of late payment or even default. One could only dream of nominal yields this high over the past decade.

Will inflation wipe out earnings?

Of course, one can quite rightly argue that while yields of 4% or 7% look great, with inflation at around 9% they just barely or do not even preserve the purchasing power of the invested capital. For now, that is a valid argument. But the current alternatives are to either settle for even lower returns (cash, savings accounts) or engage in much riskier investments (e.g. equities or foreign currency bonds). On the other hand, it is highly unlikely that the currently very high rates of inflation will remain in place over the entire maturity of the bonds. Thus, over a horizon of several years, one can certainly hope for significant positive returns on the whole, even discounting the future inflation. Naturally though, there are no guarantees for this.

Are yield increases coming to an end?

Could one wait before buying until inflation drops significantly again? Of course, that’s possible. But when inflation begins to decline visibly for everyone, prices on the bond markets will have long since priced this in. Prices are constantly trying to estimate when the increase in inflation will end, and in conjunction with this, when central banks’ rate hikes will also stop. Thus, investors who buy now run the risk of acting too soon and may face further increases in yields (i.e. lower prices). Investors who wait run the risk of only receiving significantly lower returns later on.

Yield advantage of corporate bonds shrinking

As previously mentioned, corporate bonds also offer an additional yield premium versus euro core country government bonds, which makes up a large part of the attractiveness of the former. These yield premiums have declined significantly in recent months, as negative economic scenarios for Europe have been priced out and many companies are doing better financially than anticipated. By contrast, there is now an increased risk of price declines in the event that the economic environment and financing conditions do not develop as well as is currently priced in by the market.

Fundamental situation still solid

Investment grade bonds offer roughly 1.6% p.a. more and high yield bonds around 4–5% p.a. These yield premiums are influenced by a number of different factors. Among the most important are the default risks (creditworthiness) of the bond or issuer in question, the general supply of liquidity (which is currently declining and will continue to do so for the time being), and risk sentiment on the market (which is poor right now). In fundamental terms, the current situation still looks very good. There have hardly been any defaults, and most companies have taken good advantage of the extremely low interest rates in recent years to trim back their debt, generate liquidity, and extend the maturity of their borrowings.

Higher or lower credit ratings?

Generally speaking, the higher the quality of a bond and an issuer, the lower the yield premium. However, economic conditions, fiscal measures, the monetary policy of the central banks, and the level of default risk are constantly changing. Consequently, there is no golden rule as to when one should prefer lower credit ratings with higher yields and when higher ratings with lower yields should be preferred. Added to this – and this is by no means unimportant – is the fact that interest rate risk is significantly lower in the high yield segment than for investment grade corporate bonds. In other words, the higher level of protection against default offered by IG bonds is generally associated – at the overall market level – with a higher risk of price declines in the event of increases in the general interest rate level.

At present, with regard to corporate bonds, the investment specialists at Raiffeisen KAG tend to view lower-quality assets as being too expensive in relation to the (default) risks and uncertainties (risk of recession, energy crisis, geopolitics, etc.) and still prefer higher-quality bonds and issuers.

Conclusion

In nominal terms, the yield environment for corporate bonds has improved immensely this year. Yields which have not been seen for a long time are now available on the market again. Naturally, the currently high inflation reduces the real return by a large margin (for the time being), but it is also one of the reasons for the increase in nominal yields. At the same time, companies’ earnings and cash flows are faced with significant challenges, such as the risk of recession, the energy crisis, and geopolitics, but to a great degree this has already been reflected in the increased yield premiums on corporate bonds.

Consequently, the timing for purchases may now be more favourable than it has been in many years. However, it goes without saying that there are still risks of further price declines and that price volatility may remain high. Taking a horizon of five to ten years, the risk-return profile looks quite good overall, in particular compared to less risky bond alternatives (cash, government bonds of euro core countries).