IN BRIEF

  • Has a turbulent first half created opportunities in the European high yield (HY) market? Rohan Duggal looks back at the year to date and examines what might be in store.

1. HOW HAS EUROPEAN HY PERFORMED SO FAR THIS YEAR?

As of July end, European HY1 has delivered a year-to-date total return of - 0.21%. Over the same time period, on a yield-to-worst measure, yields have increased by 80 basis points (bps) to 3.38%, while credit spreads have widened by 70 bps to end the period at 359 bps.

Negative performance can be attributed to a confluence of factors, including duration risk concerns and uncertainty surrounding the end of the European Central Bank’s corporate bond buying programme. But by and large, the main catalysts have been the heightened political uncertainty stemming from the outcome of the Italian elections, Brexit and a potential US-instigated trade war.

Importantly, these worries have not affected all sectors equally, with performance dispersion markedly higher than in 2017.

European High Yield Sector Returns: Dispersion is picking up

EHY 2017 SECTOR RETURNS
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Source: Bloomberg. ICE BofA Merrill Lynch Euro Developed Markets Non-Financial High Yield Constrained Index (HECM). Data as of 31 December 2017.

EHY YTD SECTOR RETURNS
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Source: Bloomberg. ICE BofA Merrill Lynch Euro Developed Markets Non-Financial High Yield Constrained Index (HECM). Data as of 31 December 2017.

Past performance is not a reliable indicator of current and future results

2. WHERE MIGHT VALUATIONS GO FROM HERE?

At the start of the year, we believed European HY valuations were fair when accounting for current and future default rate expectations. Fast forward to today: valuations have improved and default rates remain at historical lows (our near-term expectations are 1% vs. the long-term average of around 4%).

While recent geopolitical uncertainty has weighed on European consumer sentiment, we do not think these events yet point to a systemic eurozone crisis. Importantly, European HY corporate fundamentals remain on a firm footing. Leverage levels continue to decline and the recent volatility should mean borrowers are more protective of their balance sheet health. We are, however, keeping an eye on Q2 earnings, as higher energy prices coupled with the strength in the euro preceding the end of 1Q18 may provide temporary headwinds.

Therefore, we expect credit spreads to tighten by 10-15 bps by year end (following the 37 bps tightening already seen in July), to give a total return for the rest of the year of around 2%. Given the dispersion in performance so far this year, we do not expect these returns to be spread evenly across sectors, so to capitalise on the opportunity, investors will need to be selective.

3. HOW DO VALUATIONS COMPARE WITH THE US?

The recent political and trade-related volatility in European HY markets has pushed European credit spreads wider than the US. This dynamic presents an attractive relative value opportunity, given that the European HY market has a better credit quality profile and shorter duration than the US HY market.

The last time we observed this trend was during the global financial (2008) and European debt crises (2012)—and in both cases, it “normalised” relatively quickly.

Wider spreads compared with US HY represent a relative value opportunity

EHY VS. USHY SPREAD COMPARISON
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Source: Bloomberg, EHY: ICE BofA Merrill Lynch Euro Developed Markets Non- Financials High Yield Constrained Index (HECM), USHY: ICE BofA ML US High Yield Master II Constrained Index (HUC0), Data from January 2012 to 30 July 2018.

4. WHAT ABOUT THE TECHNICALS?

We believe the technical story has strengthened vs. the start of the year. Gross issuance levels are down 10% year on year2, driven partly by a preference among issuers to access the direct loan market and partly by recent market volatility. Furthermore, net new issuance is modest due to refinancings, while rising stars (companies being upgraded to investment grade) such as CNH and, more recently, ArcelorMittal have continued to reduce the size of the overall European HY market.

From a demand standpoint, European HY funds have witnessed continued outflows. However, the magnitude of these flows has abated in recent months given the large reduction in European HY allocations that preceded the rise in volatility.

In fact, it could be argued that technicals remain somewhat supportive given that nearly two years of consistent outflows mean European HY has not been overbought. Finally, some of the money that has recently flowed out of emerging market debt funds could find its way into European HY given the lack of liquid alternatives providing similar yields.

5. IS THE MARKET SHOWING SIGNS OF LATE-CYCLE BEHAVIOUR?

As the year has progressed, we have observed some deterioration in new issue quality, with a higher proportion of lower-rated deals and an increase in aggressive uses of funding, such as dividend payments and M&A.

The trend of weaker covenant protection continues, with just a few examples of successful investor pushback. Consequently, we have been selective in the primary market.

However, these trends impact only a small portion of the market, and we believe that European corporate borrowers continue to exhibit a genuine desire to de-leverage and to protect their balance sheets. Furthermore, leveraged buyout borrowers continue to show a preference for the European loan market, such that we expect credit quality in the bond market to hold up better as we progress through the credit cycle.

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1. Source: Bloomberg. ICE BofA Merrill Lynch Euro Developed Markets Non-Financial High Yield Constrained Index (HECM). Data as of 30 July 2018.

2. Source: Barclays – European Credit Alpha; data as of 27 July 2018.