European High Yield (EHY) has performed strongly year to date, not to mention so-called junk bonds globally have been the biggest winners since the financial crisis. Understandably investors are starting to question whether EHY’s good run this year is about to run out of steam, particularly as they look ahead to ECB tapering. Realistically the scope for further gains looks limited, but by no means is the market over inflated or in bubble territory.
Today 70 per cent of the EHY market is double-B rated (rather than single-B or triple-C rated) offering a much higher average credit quality than any point in the history of the asset class and a much high average credit quality than US High Yield (USHY). So fundamentals on EHY remain strong in what is still a very low-yielding environment.
Industry commentary has been overly facile and simplistic in drawing like-for-like comparisons between EHY and USHY of late, when in fact their characteristics differ significantly. One cannot conclude, just by comparing relative yields, that a higher yield reflects greater value, for example. This neglects a number of underlying realities. Investors should also stop fixating on the word ‘yield’ and start thinking about the ‘spread’ component in equal measure.
Yields are made up of two components. The first part is where the underlying risk-free (i.e. benchmark government bond) rates are; the second part is the additional spread investors receive for taking credit risk. So while USHY is currently yielding significantly more than EHY on an absolute basis, it is worth remembering that the risk-free rate in the US is much higher – German 10-year bunds are just 43 basis points compared to US 10-year Treasuries yielding nearly 2.2 per cent!
And, as previously mentioned, EHY is also on average much higher credit quality than USHY, meaning it should inherently be lower yielding by comparison because it’s less risky. Finally, EHY is shorter duration than USHY on average – the effective duration is four years for USHY and 3.5 years for EHY. All else being equal, investors want to be compensated with more yield for taking more duration risk, as higher duration leaves them more vulnerable to interest rate sensitivity.
Currency considerations should also be front of mind. For example a European investor considering the USHY market, who’s required to maintain their euro exposure, may need to put on a hedge which means they may forfeit some or all of the premium they get in US dollar high yield.
Having established that comparing EHY and USHY is a bit like comparing apples with oranges, what then of the investment outlook for EHY and the implications of ECB tapering? Let’s begin by putting things into perspective. The Federal Reserve has already started tapering and where have yields gone there? Rates have inched up only modestly thus far, as central banks have been careful to move at a glacial pace.
Although EHY is not going to be immune to a move out in underlying government yields, investors can still get a lot of yield for very little duration compared to most other fixed income asset classes. So while rate normalisation will put negative pressure on government bond and lower spread, longer duration credit portfolios, EHY can offer investors a potential hideout by virtue of its relatively lower sensitivity to rising rates.
Historically spreads have performed fairly well in the initial phases of an interest rate hiking cycle. If the latest tightening cycle for central banks coincides with the markets’ growing confidence in growth and inflation (both of which are good for credit quality), then this once again should be the case. It’s only when we start to see rising rates as potentially crimping future growth that they start to get negative on the credit and earnings cycle.
Within multi-sector fixed income, we’re seeing significant flows going into higher yielding asset classes including EHY. Fixed income asset allocators are interested in higher yielding credit with less duration to offset some of the potential pain of rising rates. EHY remains attractive on a relative basis plus there’s strong technical support for the market.
We anticipate EHY could achieve 6 per cent total returns or more for the full year, but investors can expect to earn carry, and not much more, for the remainder of the year. However that carry should be greater than any European core fixed income asset class right now, particularly if rates move gradually wider over the back half of the year. Duration is the biggest fear for fixed income markets today so any asset class offering low duration in a favourable part of the credit cycle, like EHY, can offer bond market investors a viable haven.
Peter Aspbury is a high yield portfolio manager at JPMorgan Asset Management