High Yield Bonds: Is it Time for a Return?

May 07, 2024 | Blog

High Yield Bonds: Is it Time for a Return?

By Babur Mirza, VP of Sales, Datasite

As market optimism continues to improve, so it seems do the prospects for high yield bonds as a debt financing tool. If central banks cut interest rates, bonds could be an attractive route to financing businesses or for financing acquisitions, and for investors hoping to maximize returns.

"After a slower 2023 for high yield bonds, we saw several issuers take advantage of a market re-opening at the start of 2024, and this provided good momentum for deals, with several pricing at the tight end of initial guidance, showing strong appetite for high yield bonds as an investment opportunity," says Capital Markets Partner James Greene of White & Case LLP.

So, as the economic landscape evolves, it's worth exploring whether now is the time for a resurgence in high yield bonds.

Understanding high yield bonds

High yield bonds, often referred to as “junk bonds”, are debt securities issued by corporations that carry a credit rating below investment grade, typically rated ‘BB’ or below by credit rating agencies. These bonds are considered riskier investments due to the increased likelihood of default compared to investment grade bonds.

Companies may issue high yield bonds for various reasons. One primary motive is to diversify their capital structure, particularly into a covenant-lite instrument which may offer more flexibility than alternative bank debt or private credit financing. High yield bonds offer these companies a way to access funds with more flexible terms, albeit at a higher cost, to finance expansion, acquisitions, or refinance or pay down debt.

Investors are drawn to high yield bonds primarily for their potential for higher returns and the call protection for fixed rate bonds, which make up the majority of the issuance. In a low-interest-rate environment, where yields on traditional fixed-income securities are meager, the higher coupon payments offered by high yield bonds can be appealing. Additionally, high yield bonds can diversify investment portfolios, providing a source of income that may not correlate closely with other asset classes like stocks or investment-grade bonds.

Challenges and opportunities

The high yield bond market has seen its share of ups and downs in recent years. The uncertainty surrounding Brexit, coupled with the economic fallout from the COVID-19 pandemic, as well as global inflation and further geopolitical risks has created challenges.  

However, inflation in the UK has fallen drastically to 3.4% (February 2024) since a high of 11.1% in October 2022, and is expected to fall below 2% in H2 2024; the Bank of England is expected to cut interest rates to 3% in 2025 (currently 5.25%), with possible interim cuts before then. And as inflation rates decline and interest rates fall, it boosts the value of bonds.

For issuers, the primary challenge lies in managing the higher costs associated with issuing high yield bonds. Companies must convince investors of their ability to generate sufficient cash flows to meet interest payments and ultimately repay the principal amount borrowed.

Additionally, economic uncertainty and market volatility can make it difficult for companies to accurately assess demand for their bonds and anticipate the ultimate pricing, which will be market-dependent and only determined at issuance, which may be several months after initially launching their bond preparatory phase. And increased financial stress on businesses and thus an increased risk of default could make high yield bonds a riskier bet. Per Fitch, the European high-yield default rate declined to 1.6% at end-February 2024 but is expected to rise towards 4% by end-2024.

Nevertheless, high yield issuance volumes totaled $156bn in Q1 2024 versus $348bn for FY23 (per Mergermarket data) – suggesting this year’s issuance could surpass that of last year. And if interest rates continue to fall and investor confidence continues to grow, it has many people wondering if high yield bonds will be a win-win for issuers needing capital and investors hoping to maximize returns this year.

"The high-yield market is the strongest it has been since 2021 for all participants: we have had record new-issue volumes; overall, falling funding costs; and increasing supply of a mix of refinancing deals and first-time issuers," says Apostolos Gkoutzinis, Partner at Millbank. “Some statistics: April was the first month since November 2021 with more than 10 deals and was the busiest month for high yield since November 2021. While we don’t have visibility for pipeline for a period that is longer than a few months, we are also not aware of any strong reason why the market will not be open in the near future.”

Whatever strategy a company pursues, whether bond issuance, M&A, or restructurings, Datasite has the tools to help. Learn more here.