Bond Bulletin
06-08-2020
GFICC Investors
Transatlantic high yield dynamics
US high yield significantly outperformed European high yield in July, with total returns now well ahead for the year, despite weaker credit fundamentals in the US. What drove this outperformance, and could it reverse?
Fundamentals
US high yield’s default rate of 6.2% for the last 12 months (as at the end of July), while lower than previous crisis levels, far exceeds the 1.8% rate for Europe. State-backed loans and access to capital markets have limited insolvencies considerably, but the cost is further indebtedness. Ironically, recognition of this fact by the rating agencies – and the subsequent unprecedented downward ratings migration – has kept the overall credit quality of both high yield markets stable, as the large number of fallen angels has bolstered the supply of high quality BBs. The US high yield market remains one notch below Europe’s average rating at B+ vs. BB-, yet it has still managed to outperform of late.
Quantitative valuations
US high yield posted total returns of 4.75% in July, well ahead of the 1.72% return for European high yield. While excess returns (returns driven by credit, excluding the impact of base rates) for the US were also more than double those for Europe in July, Europe has actually outperformed on this basis year to date. Therefore, differences in the underlying rates markets have been a significant driver of US high yield’s outperformance. To put this into context, the benchmark five-year US Treasury yield has moved 1.50% lower this year to 0.19%, while the five-year German Bund yield is only 0.25% lower at -0.73%. US high yield has also looked more appealing on a relative value basis for income-seeking investors. Hedging costs have fallen dramatically this year, such that US high yield offers a euro investor a yield-to-worst of 4.70% on a hedged basis (5.44% on an unhedged basis), vs. Europe’s 4.32%, which has likely been a driver of stronger flows into the US. (Data as of 4 August 2020.)
US high yield has outperformed European high yield significantly
Source: ICE. USHY = ICE BofA US High Yield Constrained Index (HUC0). EHY = ICE BofA Euro Developed Markets Non-Financial High Yield Constrained Index (HECM). Data as of 4 August 2020.
Technicals
Demand continues to run well ahead for US vs. European high yield. According to our proprietary fund flow monitor, US high yield retail funds have seen net inflows of over USD 40 billion this year, whereas European high yield flows are still negative, with over EUR 7 billion of outflows. Divergent supply pictures have also been a driver of relative performance. The primary market in both regions now looks to be almost shut down for the summer period, but it slowed gradually for Europe in July, vs. a steeper decline for the US, with July issuance tracking about half of June’s level. The stronger technical support for the US is evident in the fact that the main US high yield ETF (HYG) is trading at around its long-term average premium to NAV, whereas the European high yield ETF (IHYG) is trading flat to its NAV for the first time since May. (Data as of 4 August 2020).
What does this mean for fixed income investors?
The outperformance of US high yield is largely down to three factors. First, duration has performed better in the US. Second, the reduced cost of hedging US dollar assets to euros has made the market appealing for European investors. Third, US technicals have been more favourable. Absent a change in credit fundamentals, Europe could start to outperform, as US rates have already moved substantially and the supply picture in both primary markets is now similar given the August shutdown. The European market could also benefit from its higher quality status, as investors are increasingly recognising that markets have shrugged off the potential for worse data releases. In any event, both markets look set to grind tighter in the short term, given that technical conditions still seem to be supporting current valuations.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum