How to find yield beyond government bonds

As such, stocks are investments in the potential success of a company, while bonds are investments in the credit value of the company or organization itself.

“This represents a fundamental difference in how investors take on risk,” explained Jeremy Cunningham, chief investment officer for fixed income at Capital Group, in an Aug. 12 note. “What is positive from a fixed income perspective may not necessarily be positive for equity holders and vice versa.”

What moves the price of a bond?

Factors that can cause a share price to rise include profit growth, share buybacks, mergers and acquisitions, and capital expenditures (capex). Conversely, a reduction in dividends or investments or the sale of assets to strengthen the balance sheet can be positive factors for corporate bond investors.

In times of market turbulence, however, stocks and bonds do not react the same.

“During market downturns, investors focus more on the survival of companies than on their future growth potential. Therefore, before stock prices start to recover, bonds tend to rise faster,” explains Cunningham.

Types of Bonds for Coupon-Hunting Investors

Bonds are a portfolio diversification tool. Low-risk government bonds are usually used defensively. However, other types of bonds can be used to generate income. In this case, investors must be willing to accept a little more risk and sensitivity to stock market trends.

High-yield bonds, for example, are corporate bonds that offer high returns against a higher risk of issuer default. Emerging market debt also tends to offer higher returns in the face of higher risk.

Examining 20 years of data from a combination of global equity indices and high-yield and emerging market bonds, Cunningham found that it is possible to achieve a high level of return compared to a pure fixed income strategy, with lower volatility than an equity-only strategy. allocation.

“Emerging market government and corporate bonds and high yield bonds are among the most suitable instruments for portfolios seeking to generate high income,” explains Nicolò Bragazza, associate portfolio manager at Morningstar Wealth.

“These types of bonds actually offer higher yields than traditional government bonds and even higher-grade corporate bonds, and that extra yield is measured by the credit spread.”

Is now a good time to invest in high yield?

According to Justin Jewell, head of European high-yield leveraged finance at RBC BlueBay, “in today’s world, high-yield investors can realistically expect returns in the 8-9% range. Not long ago, the yields were half that,” he says. But this also carries the risk of rising default rates, which in 2021 and 2022 were at near-zero levels.

“The challenge that will slightly lower yields over the next two to three years is that defaults are expected to return to 2.5-3.5 percent,” Jewell said in a note in late July.

“After historic increases in interest rates, companies are operating in a world with higher costs of capital, and some may struggle during this time.”

Investors should also consider that high-yield bonds are very sensitive to the economic cycle, as credit spreads tend to widen during periods of increased market stress, causing the value of these bonds to decline.

“This implies that these bonds do not normally offer diversification relative to stocks,” Bragazza points out.

“Furthermore, unlike equities, their returns are capped upwards, making their risk/return profile less attractive when credit spreads are particularly compressed, particularly for those portfolios whose main objective is long term capital growth and not high level generation. income level”.

What are the benefits of investing in emerging market debt?

Emerging market debt is an alternative for those looking for high yields. It can be in foreign currency (dollar) or local currency. The latter generally carries greater risk, including currency volatility, political uncertainty and sovereign debt default – all against potentially higher and more diversified returns.

“Investing in government bonds in emerging markets can be useful not only to generate additional income, but also to benefit from the possible appreciation of the currencies in which they are issued,” says Bragazza.

“This makes them particularly attractive because the currency can provide not only additional yield but also diversification, although not as reliable as that offered by perceived high-quality currencies such as the dollar.”

Over the past two decades, emerging market debt has seen remarkable growth in terms of the breadth and depth of the country spectrum and the number of issuers.

“Issuances have increased, thus improving liquidity, while yield curves have reached a more mature stage, allowing active investors to gain value by positioning across different maturities,” noted Flavio Carpenzano, Chief Fixed Income Investments at Capital Group, in a note dated August 5. Today, this market is worth nearly $4 trillion (£3.1 trillion).

The Best High Yield Bond Funds and ETFs

For those interested in looking beyond government bonds, below are the best high-yield bond funds, selected by Morningstar medalist rating and with a Morningstar rating of at least three stars. Funds are sorted by “average coupon,” an indicator calculated by weighting each bond’s coupon by its relative weight in the portfolio. It helps you understand whether the fund holds more high- or low-coupon bonds.

Below you can find emerging market bond funds in local currencies, selected based on a positive Morningstar Medalist rating and a rating of at least three stars. Funds are sorted by average coupon.

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Now we are referring to the ETFs available in Europe. We’ve selected the best based on medalist rating in the high-yield euro bond and emerging local currency categories.