Stock markets have welcomed the US Federal Reserve’s September interest rate cut and China’s economic stimulus plan. The S&P 500 index is up 20% year-to-date, and the Chinese stock index is up by the same amount in a month. But as stocks rise, so too does the relative attractiveness of high-yield bonds. Investigate the current risk and reward profile across assets.
As the final quarter of the year begins, global conditions continue to support financial assets. We still expect the US to achieve a successful economic soft landing in 2025. Next year, real gross domestic product (GDP) in the United States should grow by 2%, while the European Union, Switzerland, the United Kingdom, and Japan will record growth of 1% to 1.5%. , China and India expanded by 4.5% and 6.5%, respectively. The central bank is likely to continue monetary easing next year. Europe’s latest consumer price index (CPI) data was lower than market expectations, leaving room for an early interest rate cut by the European Central Bank (ECB).
This provides a robust environment for risky assets. Historically, stock prices rise an average of 20% in the 12 months following the Fed’s first rate cut, as long as a recession is avoided. Additionally, the stock market tends to do well in the year following a U.S. presidential election, regardless of who is sitting in the White House. Typically, a candidate’s campaign program is implemented in the first year to energize the market.
In the year following a US presidential election, the stock market tends to do well, regardless of who sits in the White House.
But how do investors currently compensate for the risks they take across a variety of financial assets? In the U.S., equity return yields are around 3.7%, which is about 5% higher than 10-year Treasury yields and investment-grade bond yields. %. Importantly, the current earnings yield is also below that of high-yield bonds, which have an average yield of about 7%. Therefore, the risk premium (spread between earnings yield and government bond yield) for U.S. stocks is close to zero.
The situation is different in Europe and Switzerland. Here, the stock income yields are 7% and 5%, respectively, compared to the total yield on government bonds of 4% and 0.40%, respectively. The equity risk premium therefore remains positive at 3%, around the European average, and above average in Switzerland at 4.6%.
On a global level, high yield bonds currently offer the highest yields of any asset class. By comparison, stocks have about the same yield as investment-grade corporate bonds. Government bond yields are the least risky of these financial assets, but at the cost of lower yields.
On a global level, high yield bonds currently offer the highest yields across all asset classes.
High yield, detailed investigation
Of course, investors in high-yield bonds need to be mindful of default risk amid a slowing global economy. One reason this asset class currently trades at historically tight spreads relative to lower-risk bonds is low expected levels of default. Moody’s estimates the average default probability for the global high-yield segment in 2025 to be 2.9%, a relatively low threshold for starting a rate-cutting cycle. However, even if default risk rises, current yields appear to be sufficient to absorb modest credit spread widening without jeopardizing the carry advantage for investors.
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The US high-yield bond index also has a high proportion of issuers in the energy sector, which could potentially benefit from higher oil prices due to geopolitical shocks. A second Trump administration may provide additional support for U.S. high-yield bonds. Their relatively short durations, averaging 3.5 years, limit their interest rate sensitivity even if investors start to worry about inflation again. This could happen if a Republican White House raises U.S. wages by raising import tariffs or tightening immigration policies. Meanwhile, if Harris were to become president in 2025, the S&P 500 would have 31% exposure to technology stocks, compared to 7% for high yield, limiting the attractiveness of credit relative to stocks. It will be.
Second Trump administration may provide additional support for US high-yield bonds
European high-yield opportunities
In Europe, average spreads on high yield bonds are wider than in the US for several reasons. First, investors in European financial institutions demand higher compensation for perceived risks than in the United States. Second, the energy sector, with its low spreads, accounts for a large share of the US high yield market. Finally, concerns over the slowdown in Germany’s auto industry and France’s finances are also pushing spreads higher relative to the US. These widening spreads create opportunities.
For euro-based investors, high-yield corporate bonds perform better than equities, and both offer a better risk-reward profile than investment-grade bonds or government bonds. For Swiss Franc-based investors, Swiss real estate and stocks outperform Swiss government bonds and investment grade credit.
While returns from stocks have been particularly strong so far in 2024, corporate bonds remain a useful portfolio tool. We are also beginning to add diversification benefits, such as the correlation between stocks and bonds decreasing to more typical levels. We currently have a strategic weight in our portfolio across equity and fixed income allocations (both investment grade and high yield bonds). With the US election just weeks away, the investment risk and return landscape continues to change rapidly.
CIO’s perspective
High-yield bonds regain their luster
