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European High Yield: defaults are what really cost you

Following the September sell-off, valuations in European high-yield (EHY) are looking attractive once again. Volatility is to be expected in the short term, but the asset class has proven its worth in testing economic times.

Recent years have seen strong growth trends in the European corporate debt markets. This has provided a solid base for EHY to grow, becoming increasingly diversified and more appealing to investors as a result. With two full credit cycles since the late 1990’s behind it, the EHY sector is now an integral part of the global leveraged finance market.

There’s plenty of literature out there talking up the benefits of EHY versus its bigger – and uglier – brother in the US. While returns this year haven’t been as strong, credit quality is higher this side of the pond, largely thanks to fallen-angel issuers whose credit ratings have fallen from investment grade to high-yield. Divergent monetary policy is another positive factor in favour of the smaller brother, as is the fact EHY isn’t exposed to the debt-saturated US energy sector.

But that’s all old news. What really costs investors in high-yield markets are defaults; if a company fails to deliver on its debt obligations, it tends to spell trouble.

Resilience clearly matters then. In times of uncertainty, investors traditionally flock to the ‘safe haven’ assets, such as government and investment grade bonds. In normal economic conditions, these would offer a relatively safe spot to park your cash. But these aren’t conventional times; central banks have exhausted their weaponry, 85% of developed market bonds now yield less than 1%, and 30% of those offer negative yields. Then there’s the small issue of Brexit, key elections in Europe and, of course, uncertainty over what a Donald Trump presidency will bring.

Naturally, you’d be forgiven for thinking that going down the risk spectrum to higher-yielding assets doesn’t make much sense. After all, higher-yield surely means higher volatility?

EHY has fared significantly better than many might expect in sell-off periods.

Not necessarily. Going against the perceived logic of high-yield investing, the EHY sector doesn’t get the respect it deserves in terms of its defensive qualities. It’s often overlooked by investors and market commentators, especially during risk asset drawdowns and duration sell-offs. Risks will always loom, as they do in all asset classes, but analysis reveals that EHY has fared significantly better than many might expect in sell-off periods.

So what are the facts? Taking the backend of 2011 – a period following heavy selling in a low default environment – EHY performed surprisingly well versus other asset classes. European equities, for example, returned -18.83% compared to EHY’s -6.52%. While it’s still a negative return, there was considerably less volatility when compared against most of the other classes. In fact, on a volatility of returns level, EHY was correlated most with that of bund returns during the period.

Source: Bloomberg, as at 01 November 2016

Past performance is not a guide to future returns.


 

In 2013, it was a similar story. EHY saw heavy outflows early on in the year but, despite the sell-off, high-yield bonds produced an impressive 7.52% for the second half. In comparison, the ‘safer’ bunds produced a negative -0.72% return for the same period. Impressively, as the graph below highlights, EHY was the only asset class among those listed not to produce a negative monthly return for the six month period.


 

Source: Bloomberg, as at 01 November 2016

Past performance is not a guide to future returns.


 

And the myth busting continues. EHY experienced six months of outflows between April and September last year. It was a big risk-off period in global markets as fears around China’s slowdown grew. Most asset classes took a beating, but the EHY index was fairly stable throughout, despite ending the period down -3.42%. As you might expect, equities were highly volatile. The returns were also significantly worse, with the Euro Stoxx, FTSE 100 and S&P 500 all down -16.76%, -10.51%, -7.13%, respectively.

Source: Bloomberg, as at 01 November 2016

Past performance is not a guide to future returns.


 

EHY is not a perfect asset class. There is no such thing. Of course, it has underperformed during certain periods of turbulence, but this analysis does shed light on how asset classes don’t always behave the way investors think they might. Still, there’s plenty on the horizon to potentially concern investors.

Alongside the various political risks and slowing global growth concerns, assessing the true value of the asset class has also become increasingly difficult since the start of the European Central Bank’s (ECB) quantitative easing (QE) programme. It’s been made more complicated by the introduction of the corporate sector purchase programme (CSPP), a further addition to the QE arsenal. Furthermore, Mario Draghi, president of the ECB, has hinted that QE will be tapered at some point. The action caused a spike in volatility, distorting bond markets further.

It’s likely to be a bumpy road ahead for European high-yield bonds, as it will be for markets globally, but the combination of yield and relatively low duration in return for its credit risk remains compelling. It’s clear the reputation of the asset class has grown, and EHY certainly warrants the increased interest among fixed income investors.





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