Looking to the European market for high yield

Unprecedented central bank intervention, sovereign default risk, credit rating shifts and investor demand have all shaped the market, which has more than tripled since 2008. Investors have been attracted by improving credit quality, low default rates and increasingly elusive yields elsewhere.

The credit rating composition of the European index reveals that almost 70 per cent of the index is now rated BB, up from just more than 44 per cent in 2008, and only 8 per cent is rated CCC or lower. This is in contrast to the US, where BB and B-rated issues both account for approximately 40 per cent of the index, and issuance rated CCC or below accounts for some 20 per cent.

This improvement in the ratings mix is partly due to fallen angels joining the market after losing their investment-grade rating. Fallen angels include companies downgraded for idiosyncratic reasons (such as ArcelorMittal and Nokia), as well as Portuguese companies (such as EDP and Portugal Telecom) downgraded due to proximity to sovereign risk. These names added approximately €76bn (£64.8bn) and a further €5bn in January 2013. Maturities (and durations) are also shorter now, for at least two reasons:

- The market standard maturity has shortened from 10 years (no call within five years) to seven years (no call within three years) post financial crisis.

- Fallen angels tend to leave their short-dated debt outstanding for longer (and so closer to maturity) because former investment grade companies typically have better liquidity and less refinancing risk (they are not as reliant on capital markets as high yield issuers).

In the past 18 months, there has been a prolonged tightening of spreads in developed high yield markets. This has come as investors search for risk-adjusted yield, and companies are able to refinance cheaply, with interest rates being kept close to zero. In contradiction to history, this has been against a backdrop of weak GDP growth – the five largest economies in the eurozone all contracted in the fourth quarter 2012.

Default rates have historically shown a negative correlation to GDP growth, but this has not been the case during the current weak economic climate. This has been a result of companies strengthening their balance sheets through the downturn that immediately followed the financial crisis.

With spreads grinding tighter, some have been calling for a ‘Great Rotation’ out of fixed income assets and into equities. Concerns are being voiced that the market is overpriced and flows are technically, rather than fundamentally driven.

But it is hard to argue with the asset class’s fundamentals, the relative predictability of fixed coupons (compared to equities), and seniority, without a significant uptick in the economic outlook. The eurozone will deal investors both surprises and disappointments, fuelling intermittent bouts of ‘risk-on’ and ‘risk-off’ behaviour, but Citi’s Economic Surprise index for Europe shows that no period of continued positive or negative surprises has lasted for more than six months since late 2010. A more tangible and sustained improvement in the European economy will likely be necessary before funds are meaningfully reallocated to a more volatile asset class.

Given the recent contraction in European GDP (-0.9 per cent year-on-year, fourth quarter of 2012), record unemployment (11.9 per cent in January 2013), and below target inflation (1.8 per cent in February 2013), it seems unlikely that such a reallocation will occur in the near future.

Investors in European high yield might ask – ‘given that yields have fallen considerably, am I being fairly compensated for the risk in my portfolio?’ It can be said that yields, although low, still pay investors for the risk in a well constructed high yield fund, especially given the level of sovereign yields.

Investors should not pretend to be able to time the markets – there will very likely be better entry points to the asset class at some point in the future. The question is whether it is worth foregoing coupon income to wait for this. Given that default rates are well below their historical averages and that corporate balance sheets are strong, when asked about timing an investment, it is usually suggested to slowly build a strategic allocation over time.

Unfortunately, we are unlikely to see returns in 2013 like those of 2012, but investors who have maintained an allocation to high yield historically have tended to see enhanced risk-adjusted returns through the cycle.

Defaults are the key driver of performance in this asset class, and the most important risk to high yield bondholders. Although default rates are currently exceptionally low, in time it is expected they will creep back up to more ‘normal’ levels. There has been an increase in lower quality credits in the European index in the past six months, and expect this to continue, as rates are kept ‘lower for longer’.

Investors should be aware that these companies may be the first to suffer when interest rates do rise, or appetite and flows into the asset class fall away. This trend will do nothing but increase the importance of in-depth fundamental analysis. We believe that an experienced and thorough investment manager can mitigate much of this credit risk.

The recent tightening of the entire fixed income universe has highlighted the value that investors rightly place in certainty of income, return of capital, and seniority in the capital structure. This cannot be understated, and while we are in a low-yield world, investors should be aware of the risks that they take in search of additional potential reward.

Thomas Samson is a global high yield analyst at Muzinich & Co