European high-yield bonds look primed to offer a relatively stable source of income over the next couple of years.
It’s almost a decade since the financial crisis started and even now finding a safe source of income is a formidable challenge. We believe European high-yield (“junk”) bonds will prove hard to beat for stable, risk-adjusted yield over the next couple of years.
The key factor is that default rates look set to remain at all-time lows. Ratings agency Moody’s forecast a 2% default rate for European high-yield debt this year, down from the current trailing rate of 2.5%. Low defaults equate to low volatility; and we have reason to think this will continue.
A bond defaults for one of two reasons. Firstly an issuer can’t pay when a debt becomes due, either because it does not have the cash or can’t borrow the money. Secondly, an issuer is unable to service prevailing interest payments on its debt.
Currently, however, borrowing costs in Europe are rock bottom and appear set to stay that way for some time, which substantially improves solvency ratios at a market level. On average, European high yield company can refinance its debt today at a third of the cost it would have had to pay five years ago. Refinancing risk is also low by historic standards. The debt maturity profile of the market is evenly distributed, with no single year representing a “maturity wall” and a spike of refinancing needs. Furthermore, lower rated bonds represent less than 50% of the markets refinancing needs over the next four or five years, which again reduces risk.
Government (sovereign) bond yields are extremely low, even negative, in Europe, and look likely to remain so for the foreseeable future. This has driven demand for high-yield bonds, since investors have had to reach into the market in search of higher returns. The European Central Bank (ECB) extending its bond-buying programme further underpins future demand.
Strong demand and low defaults have compressed the difference (spread) between government and corporate bond yields.
Strong demand and low defaults have compressed the difference (spread) between government and corporate bond yields. Today the redemption yield of the European high-yield bond market is 3%, versus 10% five and a half years ago. But this is set against a 5-year German bund yield of -0.5%. We see this 3.5% yield spread as attractive in an environment where the high-yield default rate – in other words, the risk of crystalized loss – looks set to remain low. (All figures sourced from Bloomberg, March 2017)
Certainly demand has driven up bond prices. The neutral price (par capital value) of a corporate bond is 100. Investors currently have to pay 104, on average, to buy a high-yield bond. This causes capital depreciation over time. If an investor pays 104 for a four-year bond that offers 5% interest (coupon), they simplistically lose 1% a year in capital value over the life of the bond. But, all things being equal, if they hold the bond until maturity they still end up with an annual return (yield) of 4%.
The most important question for investors to ask is what might cause default rates to rise? We see three potential causes, but attach a low near term probability to each.
Firstly, it’s possible that an anti-establishment candidate wins the French or Italian election, or that the refinancing of Greece’s debt falls apart. (We see a reasonably low risk of a messy Brexit divorce from the European Union on the grounds an acrimonious exit benefits neither side. The timeframe for Britain’s exit is also likely to be long and may now have been further extended by the announcement by Prime Minister May that she wants a general election in June.)
If Marine Le Pen of the National Front or Beppe Grillo’s Five Star Movement prevails in national election, it could precede a break-up of the Union, which would likely cause a significant sell-off. Positively, Le Pen was crushed in presidential debates and looks unable to garner enough second-round votes to defeat frontrunner Emmanuel Macron. In Italy, Five Star’s Virginia Raggi has lacked credibility as Rome’s mayor, which is undermining confidence in the group’s governing capabilities.
We can expect the refinancing of Greece’s debt in July to go through. If Greece was allowed to default and was forced out of the single currency, it would set a precedent that would raise doubts about the eurozone’s sustainability. There is no mechanism for a country to exit the euro. Policymakers have already demonstrated a determination to do whatever it takes not to let this happen. There’s no reason to think they have changed their minds.
The second risk is that the European economy nosedives back into recession. Yet Europe is showing nascent signs of recovery, with manufacturing orders, retail sales and business and consumer confidence all picking up. Companies are being conservative with their balance sheets. Corporate debt levels have barely risen in Europe even as the cost of debt has fallen dramatically. Firms are leaner and more efficient than they were pre-crisis.
Confidence breeds investment, which equates to more jobs and increased spending.
Even if Europe’s recovery has been built on monetary accommodation, such growth can become self-fulfilling. Confidence breeds investment, which equates to more jobs and increased spending. In economic terms it’s the Keynesian multiplier effect. In our view, economic momentum and political status quo make a recessionary outcome unlikely in the near future.
The third – and most plausible – risk is that European growth exceeds expectations. While easy monetary policy is supportive in the near term, the central bank would err by leaving policy too loose for too long. This would drive up inflation and growth to a point where the ECB would have to act suddenly to tighten monetary policy. It would be the equivalent slamming on the brakes when driving at 100 mph, and it would cause a shock to markets. Stronger than expected growth could also lead to more aggressive lending behaviours and equity-friendly management, which can act as a signal we are entering the final phase of the credit cycle.
The data, however, points to a gradual economic recovery, suggesting the ECB can muddle through on growth and inflation. If it is able to tighten policy in orderly fashion then markets will start to normalise. At that point we would expect populism – which thrives on economic and social unrest – to lose steam.
Even if growth did surge up to 3% or more, we suspect markets would like that more than they disliked it, at least initially. Any negative side effects could take years to materialise, meaning bond holders would continue to enjoy a nice coupon in the meantime.
For the foreseeable future we see no grounds for record-low default rates to rise materially. This supports our case that European high-yield bonds will provide a relatively stable source of income for longer term investors.
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