Strong equity market volatility and low yields mean HNW investors are exploring riskier corners of the fixed income universe. As the economy is not quite out of the woods yet, a word of caution is in order. Defaults are likely to continue to creep up and wealth managers need to ensure their clients recognize the risk.

There has been a shift towards high yield bonds within investors’ fixed income portfolio over the past few years, with the proportion rising to from 12.9% in 2018 to 14.8% in 2019 and 17.2% in 2020. S&P data shows a 2.8% spike in the global speculative-grade corporate default rate in 2019, up from 2.1% at the end of 2018, with 118 global corporate defaults. Given the economic blow following the outbreak of the pandemic, we expect the number of defaults to creep up further, exposing high-net-worth (HNW) investors to heightened default risk. At the same time, more companies are expected to lose their investment grade status, following in the footsteps of such venerable brands as Renault, Kraft Heinz, and Marks & Spencer.

While having increased as a proportion of direct bond holdings across most countries, there are a number of geographies that stand out – both in terms of exposure and in terms of default risk. In regards to the latter, the US is forecast to see a higher proportion of defaults, with S&P forecasting the 12-months corporate default rate to rise to 12.5% by June 2021 from 6.2%, while Europe’s rate is expected to rise from 3.8% to 8.5%.

We also have already witnessed a number of high-profile defaults of state-owned companies in China that traditionally have been regarded as safe investments. The first-time default rate for state-owned entities (SOEs) is well below 1% currently, which compares to 9% among private enterprises. However, the Chinese government’s support has become more selective as resources have become scarcer and SOEs – including miner Yongcheng Coal, Huachen Automotive Group, and government-backed chipmaker Tsinghua Unigroup – have already defaulted in 2020.

Chinese HNW investors’ exposure to high-yield bonds is limited though, with an allocation of just 1.5% of total onshore wealth. The proportion rises to 2.5% in the US and 3.3% in Europe, with the highest allocations in Switzerland (4.4%) and Belgium (4.0%).

While record-low interest rates have a positive effect on debt servicing cost, they will continue to encourage investors to opt for higher-yield bonds. The economic recovery is unlikely to start before the second part of 2021, and wealth managers will do well to monitor their clients’ fixed-income allocations closely. For the fifth consecutive year, it was the consumer services and energy and natural resources sectors that dominated defaults, accounting for almost half of the total in 2019. It will be these sectors, in addition to the tourism sector, to keep a close eye on as we move into the next year.