European NIRP provides positive backdrop for high yield

For those seeking income, the options are limited among assets traditionally held in portfolios for these purposes, such as government bonds and higher yielding UK equities.

UK gilts are paying very little interest, while the volatility of equities, real threat of negative returns and risks to the sustainability of many higher yielding stocks’ dividend payments in a low growth economy, mean they offer little upside but plenty of downside risk.

So where should investors be looking instead? An allocation to European high yield could help investors solve the dilemma of how to generate a reliable and low volatility income stream.

Why is now a good time for European high yield?

Last year, European high yield, as measured by the relevant Bank of America Merrill Lynch index, delivered a fairly unremarkable 0.75 per cent, yet some fund managers were able to outperform this return by considerable margins, perhaps fourfold or more, with significantly lower volatility than the index’s 5.92 per cent.

The conditions in 2016, particularly following the ECB’s latest stimulus measures, have created a better environment for the asset class, meaning we are likely to see a higher benchmark return than last, while good quality active fund managers should be able to do better still.

In Europe, as in much of the developed world, high levels of debt and low economic productivity have been persistent problems for many years. The ECB’s introduction of negative interest rates and expanded QE programme that will include buying investment grade corporate credit, will have various net positive effects and so have been broadly welcomed by markets.

They signal that interest rates will remain lower for longer, easing fears of any major sovereign defaults and possible knock-on effects across the eurozone. The ECB had thus demonstrated, again, its willingness to take meaningful steps to fend off the threats of deflation and recession.

Crucially, the measures support European high yield. For high yield issuers and lenders they instil confidence in each other. In a low growth environment, while it may not be easy for issuers to grow their earnings and engage in shareholder-friendly activities, they should be able to continue to pay their debts.

Meanwhile, amid already low yields elsewhere, the ECB’s latest round of QE is likely to see more government bonds pushed into negative yield territory and yields on investment grade compress, providing more market support to high yield issuers.

Investors have a clear incentive to lend to high yield companies and enjoy the relatively attractive income levels they receive from doing so.

Against this backdrop, the risks in European high yield are arguably reduced. Growth is low, but supported, and interest rates may not rise for some time. Risks can come down further through prudent credit research and selection to help ensure companies will be able to pay their debts and not default.

There are many high quality companies to be found in the European high yield universe. Many are large, well-known names and some are so-called fallen angels that have dropped into the high yield universe from investment grade, having taken on more debt than usual during a challenging economic cycle. Carefully selected, such companies can mean investors are effectively getting investment grade investment security with high yield coupons.

Many others are simply fundamentally robust businesses whose operating models work on them being more leveraged than most, pushing them into the high yield universe. This does not mean they are necessarily any less able to meet their debt repayments. Again, credit research is vital in this respect.

Erick Muller is head of markets and strategy at Muzinich & Co.