High-yield Scandinavian bonds: better positioned than US and European bonds

Svein Aage Aanes, head of fixed income at DNB Asset Management

Bonds are once again promising attractive returns. Inflation is dropping faster than expected in many countries, creating favorable conditions for the global interest rate hiking cycle to come to an end. For investors unafraid of risk, high-yield bonds, in particular, offer an intriguing alternative.

This asset class includes bonds issued by comparably lower-rated issuers. As their default risk is higher, they offer correspondingly higher yields. Apart from the current generally high interest rates, high-yield bond issuers usually have to offer strong risk premiums to compensate investors for the increased default risk. In the case of Scandinavian high-yield bonds, for instance, this risk premium, commercially known as a credit spread, is currently about 200 basis points higher than the average in the US and Europe. Therefore, investors receive about two percent more return for the same credit risk in Nordic bonds than in the US and the rest of Europe.

However, investors should note that part of the higher interest rate obtained from high-yield bonds may be necessary to cover losses from companies that are no longer able to offset their deficits. Net losses of around one percent of the portfolio per year are common in markets like the US. During periods of pronounced economic weakness, these losses can quickly double.

Above-average long-term returns

Furthermore, it might be challenging to raise capital in the high-yield bond market during periods of market volatility. This could make it difficult to sell bonds at favorable prices and lead to greater price fluctuations.

On the other hand, these bonds typically recover relatively quickly when markets calm down. Interesting fact: unlike shareholders, bondholders have a right they can enforce in court if necessary. Even in the event of bankruptcy, bondholders can claim residual value.

Investors are being well compensated for the underlying risks in the current environment. The most significant aspect from an investor's perspective is undoubtedly the attractive yield premium. Currently, this premium is on average about 200 basis points higher than that of high-yield bonds with comparable credit risk in the US and the rest of Europe. Moreover, investors can currently achieve significantly higher yields than the long-term average annual returns generated by high-yield bonds worldwide.

DNB Fund High Yield vs. Benchmark Index

In this context, Scandinavian high-yield bonds represent a promising market. The Nordic economies are efficient and well-positioned, bond yield premiums are attractive, and interest rates have likely already experienced their most pronounced increase.

It is often very challenging for private investors to access this segment, as it is easy to make wrong decisions without a deep understanding of issuer solvency and the macroeconomic factors influencing the high-yield market. In this case, funds not only offer the advantage of diversified investment but also the opportunity to achieve returns similar to equities with lower risk and reduced volatility.

In recent years, a correlation has emerged between risk and potential returns. Despite declines during the pandemic and during the 2014 and 2015 oil price slump, for example, the DNB High Yield A fund has had significantly better returns than Norwegian investment-grade funds. In the case of a mild economic recovery, an annual return of eight percent is possible.

Since a fund can take one or two years to recover from significant declines in its value, these investment portfolios are more suitable for investors with a relatively long investment horizon, preferably exceeding three years.