Weekly Bond Bulletin: Transatlantic high yield dynamics - J.P. Morgan Asset Management
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Weekly Bond Bulletin: Transatlantic high yield dynamics

Contributor GFICC Investors

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 marketFederal Open Market Committee members have hinted that a shift in the Fed’s inflation-targeting approach to outcome-based forward guidance may be on the cards. The Fed has a dual mandate of employment and price stability, with the price stability part of the equation currently represented by a 2% core PCE inflation target. However, this target has been more of a guide, as the Fed has raised rates when PCE has been below 2%. Under outcome-based forward guidance, there would be no hiking until inflation moved sustainably above 2%. In fact, only one of the three hiking cycles in the US over the past 25 years would have happened under such a regime. Therefore, the shift could have meaningful repercussions for policy decisions. Not only would it mean that the Fed could remain on hold for a significant period of time, but also that policymakers may need to use further accommodative tools to avoid falling short of their inflation target.

 Quantitative valuations

Government bond markets have already been pricing in the expectation that rates will remain low for some time. The US benchmark 10-year government bond yield, which started the year at 1.92%, has fallen meaningfully to 0.58%. For credit markets, a shift to outcome-based forward guidance means we can’t necessarily compare current valuations to historical levels as an indication of fair value. Current spreads for US investment grade and high yield markets, at 140 bps and 529 bps respectively, are both close to long-term averages. These levels may seem relatively meagre given the recessionary backdrop, but could actually present opportunity for further compression under the new regime. (Data as of 28 July 2020).

US high yield has outperformed European high yield significantly

The Fed has previously hiked rates without core PCE being sustainably above 2%

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.


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