High yield investors in Europe are starting to become risk averse, especially given the coming earnings season. This could be the first sign that yields may need to pick up in junk bonds after a pretty strong 9% rally that they have seen in 2019 year to date.

Source: Bloomberg

The Dutch retail outlet Hema BV saw its bonds drop by 50 cents on the dollar on lower quarterly EBITDA and Codere SA, the Spanish based gambling company also saw its bonds drop by 10 cents on the dollar when it lowered earnings guidance.

Could this be the first warning sign that yields are about to jump on junk bonds? There certainly is a case for yields to climb in the EU. As mentioned in previous posts, German manufacturing is slumping and the composite PMI for the Euro area, a gauge which looks at sales, new orders, employment, inventory and prices across manufacturing and services, also tumbled in September.

Source: Bloomberg

Despite this, we haven’t seen a pick up in yields…yet. The Bank of America High yield index is currently yielding 4.31% and is still relatively low compared to both its historical average and the jump in yields it saw with a wave of bad news in late 2015 and early 2016.

Source Federal Reserve

While the mainstream financial press will remain focused on stocks, keep an eye on junk bonds. They tend to move with high correlation to the stock market but are not as volatile. Yields tend to jump when there is a wave of defaults, usually when the economy turns sour. When this happens, it may be a good time to jump in if you can stomach the volatility.

It’s also an attractive asset class for those with low or no other income because the majority of the return is taxed at a short term rate. Some believe this also makes it a good asset class for untaxed portfolios as well such as IRA’s. I personally don’t put any there but some people see the benefit through diversification.

The below can give you an idea of the risk and reward of junk bonds. Returns since the 1960’s have been about 23% lower than the return on equity but with about 43% less volatility.

Source: Yieldstream

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