When High Yield Becomes Low Yield

In December 2008, as the “world was ending,” European junk bonds hit a record high yield of 25.97%. Forecasts of financial Armageddon were widespread, and few could envision a scenario in which subordinated bondholders would receive anything but pain.

Effective yield of European high yield index graph1

But the world did not end in December 2008. And over next five years, European junk bondholders would receive nothing but pleasure, earning a record return of 23% per year.

Fast forward to today and we have reached the opposite extreme, with European junk bonds at an all-time low yield of 2.67%.

Effective yield of european high yield index graph2

Say what now? 2.67%!

Yes, I’m as stunned as you and I’m the guy who wrote last year that “there is no impossible in markets.”

With negative interest rate policy in place for two years now throughout Europe, investors are doing what they do best: reaching … for … yield.

Global 2 year yields chart3

While reaching has been harmless thus far in 2017 as yields continue to fall, the inevitability of bond math is lurking: lower starting yields = lower future returns.

And at a 2.67%, this suggests the prospective returns for junk bonds in Europe have never been lower. Unless negative interest rates policy somehow leads to a negative default rate, buyers of these bonds today are going to be highly disappointed.

Exactly when are they going to be disappointed? I don’t know. A low yield can go always lower and it can take time before a poor risk/reward translates into a poor return. In the last cycle, European junk bond yields hit a low of 5.38% back in February 2005. These bonds would go on to gain an additional 19% (total return) until they peaked more than two years later, in June 2007. But they would soon give that all back, and by December 2008 buyers of junk bonds from February 2005 had a cumulative loss of close to 30%.

Will the same thing happen today? No, every time is different and we are already in uncharted territory here. Counting on the same outcome as the past is a fools game.

The best we can say when high yield becomes low yield is that investors would be wise to proceed with caution. Negative interest rates may defy rationality but they do not defy bond math and risk/reward.


Related Posts:

When to Fear High Yield

There is No Impossible in Markets

The Single Best Predictor of Bond Returns 

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.


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