Fascinated by income

21/03/2019

Download

​Tom Ross, corporate credit portfolio manager, looks at the idiosyncrasies of the European high yield bond market, one of the last bastions of income in a yield-starved world.


‘It is better to have a permanent income than be fascinating’, claimed the celebrated novelist and playwright Oscar Wilde. As bond investors who are often unjustly characterised for being dull and conservative by our equity cousins, we might take umbrage with the latter part of this quote but would wholeheartedly support the premise of a reliable income.
 
For investors in Europe, trying to achieve an attractive income has become increasingly challenging. Expectations that the European Central Bank (ECB) would follow the US Federal Reserve and raise interest rates have been dashed. In part, by the US Federal Reserve itself, whose dovish pivot away from further tightening has taken the pressure off other central banks. For the most part, however, central banks are responding to the general economic slowdown, hesitant to tighten further for fear of choking off economic growth.
 
For now, the expectation is that the key monetary policy interest rate in the eurozone will remain at zero, the level it has occupied since March 2016. In fact, at its policy meeting in March 2019, the ECB stated that interest rates would remain at current levels to the end of the year. In the absence of higher inflation or an economic growth spurt this is likely to anchor government bond yields at low levels. For investors looking for income this leaves scant pickings at the safest end of the credit spectrum: the yield on a short-dated 3-month German bund was in negative territory in early March, with even the 10-year German bund offering less than 0.1%1. With inflation in the Eurozone running at 1.5% in the year to February 2019, investors in bunds are essentially accepting a reduction in their real-term spending power in return for the backing of the German government.
 
German bund income failing to keep pace with inflation
1

Source: Thomson Reuters Datastream, 28 February 2014 to 28 February 2019, Eurozone CPI, Datastream benchmark 10-year German government bond redemption yield.
1Source: Thomson Reuters Datastream, at 7 March 2019, Datastream benchmark 10-year German government bond redemption yield. Yields may vary and are not guaranteed.
 
Moving further along the credit spectrum to investment grade corporate bonds – debt issued by a company with a AAA+ to BBB- credit rating – offers more in the way of income. The ICE BofAML Euro Corporate Index yields 1.0%2. Yet it is sub-investment grade bonds – high yield – where the yield truly becomes fascinating, with the ICE BofAML European Currency High Yield Index yielding 4.1%2.
 
2Source: Bloomberg, at 7 March 2019. Yields may vary and are not guaranteed
 
Within this yield figure is a premium for risk – the very real risk that a company could default and fail to meet its obligations either in terms of payment of coupon (regular interest payments) or repayment of par to investors. High yield defaults in Europe have been low – just 0.9% on a 12-month trailing basis to February 2019 according to Moody’s the credit rating agency. The default rate is expected to climb but remain below the historical 15-year average of 2.7% in the coming 12 months as refinancing remains accessible and the rates companies have to pay remain low.
 
Borrowing companies should be able to find willing investors in their debt so long as the economic outlook does not deteriorate too much. Given the idiosyncratic risk among high yield borrowers it is therefore worth looking closely at corporate fundamentals. High yield as a classification covers a wide spectrum of debt-issuing companies in various states of creditworthiness. There is a big difference between a high yield bond rated lower down the ratings spectrum at B- and one with the highest quality high yield rating of BB+. For example, credit rating agency Standard & Poor’s compiled data on high yield European bonds between 1981 and 2017, which showed that over a five-year time horizon a cumulative 23.99% of the B- rated bonds defaulted, compared with just 0.56% of BB+ rated bonds. There is clearly a trade-off between capturing a higher yield and assuming more default risk.
 
More important perhaps than the credit rating is the direction of travel. A company rated BB- but with improving fundamentals is potentially more attractive than a company rated BB+ but with a deteriorating outlook. This is especially true in an age where disruption can rapidly undermine the business model and cash flow of a company. Recent defaults are symptomatic of this changing world: for example, Astaldi, an Italian construction company, was a victim of economic weakness in Italy that made its debt servicing costs too onerous while political turmoil in Turkey hampered its efforts to raise cash from asset sales; or Johnston Press, a UK regional newspaper publisher, which has seen the trend to online media consumption and a shift to digital advertising hollow out its revenues.
 
In the other direction are companies that are benefiting from improving circumstances or self-help measures. Such companies are likely to see their bond prices rise or remain stable as investors have greater confidence in income payments being met. In the UK, Tesco, the supermarket group, has worked to reduce its net debt and compete with discount supermarkets. It has already gained one investment grade rating from rating agency Fitch and may be on the cusp of receiving full investment grade status if one of the other two rating agencies follows suit. Companies that fully moved to investment grade status in 2018 included Stora Enso, the Finnish pulp and paper group, and ArcelorMittal, the global steel company headquartered in Luxembourg.
 
It might be assumed that the macroeconomic backdrop dictates when companies are downgraded from investment grade to high yield (fallen angels) and when they are upgraded from high yield to investment grade (rising stars), yet the reality is more nuanced. Often there is a time lag between the economy deteriorating and companies getting into difficulty – there were few fallen angels in 2008-09 – yet plenty in 2015/16 when the rapid oil price decline caused a broad sector de-rating. We did say high yield was fascinating.
 
 
Glossary:
Bund: German government bond
Yield: The income that a bond pays as a percentage of its bond price. A bond paying €3 per annum with a price of €100 would have a yield of 3%.
ICE BofAML:  Intercontinental Exchange (ICE Data Services) acquired Bank of America Merrill Lynch’s fixed income index business and renamed these indices ICE BofAML.
Credit ratings: A score assigned to a borrower, based on their creditworthiness. It may apply to a government or company, or to one of their individual debts or financial obligations. An entity issuing investment-grade bonds would typically have a higher credit rating than one issuing high-yield bonds. The rating is usually given by credit rating agencies, such as Standard & Poor’s or Fitch, which use standardised scores such as ‘AAA’ (a high credit rating) or ‘B-’ (a low credit rating). Moody's, another well known credit rating agency, uses a slightly different format with Aaa (a high credit rating) and B3 (a low credit rating) as per the table below. The ratings spectrum starts at the top with AAA (highest quality) and progresses down the alphabet to C and D, which indicate a borrower that is vulnerable to defaulting or has defaulted.
5




These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

For promotional purposes.


Important information

Please read the following important information regarding funds related to this article.

Janus Henderson Horizon Euro High Yield Bond Fund

This document is intended solely for the use of professionals and is not for general public distribution.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Any investment application will be made solely on the basis of the information contained in the Fund’s prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the Fund’s prospectus and key investor information document before investing. A copy of the Fund’s prospectus and key investor information document can be obtained from Henderson Global Investors Limited in its capacity as Investment Manager and Distributor.

Issued in Europe by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Past performance is not a guide to future performance. The performance data does not take into account the commissions and costs incurred on the issue and redemption of units. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

The Fund is a recognised collective investment scheme for the purpose of promotion into the United Kingdom. Potential investors in the United Kingdom are advised that all, or most, of the protections afforded by the United Kingdom regulatory system will not apply to an investment in the Fund and that compensation will not be available under the United Kingdom Financial Services Compensation Scheme.

Copies of the Fund’s prospectus and key investor information document are available in English, French, German, and Italian. Articles of incorporation, annual and semi-annual reports are available in English. Key Investor document is also available in Spanish. All of these documents can be obtained free of cost from the local offices of Janus Henderson Investors: 201 Bishopsgate, London, EC2M 3AE for UK, Swedish and Scandinavian investors; Via Dante 14, 20121 Milan, Italy, for Italian investors and Roemer Visscherstraat 43-45, 1054 EW Amsterdam, the Netherlands. for Dutch investors; and the Fund’s: Austrian Paying Agent Raiffeisen Bank International AG, Am Stadtpark 9, A-1030 Vienna; French Paying Agent BNP Paribas Securities Services, 3, rue d’Antin, F-75002 Paris; German Information Agent Marcard, Stein & Co, Ballindamm 36, 20095 Hamburg; Belgian Financial Service Provider CACEIS Belgium S.A., Avenue du Port 86 C b320, B-1000 Brussels; Spanish Representative Allfunds Bank S.A. Estafeta, 6 Complejo Plaza de la Fuente, La Moraleja, Alcobendas 28109 Madrid; Singapore Representative Janus Henderson Investors (Singapore) Limited, 138 Market Street, #34-03 / 04 CapitaGreen 048946; or Swiss Representative BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich who are also the Swiss Paying Agent. RBC Investor Services Trust Hong Kong Limited, a subsidiary of the joint venture UK holding company RBC Investor Services Limited, 51/F Central Plaza, 18 Harbour Road, Wanchai, Hong Kong, Tel: +852 2978 5656 is the Fund’s Representative in Hong Kong.

Information on this document is on Janus Henderson Investors’ best endeavours.

Specific risks

  • This fund is designed to be used only as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • The value of a bond or money market instrument may fall if the financial health of the issuer weakens, or the market believes it may weaken. This risk is greater the lower the credit quality of the bond.
  • If the Fund or a specific share class of the Fund seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Any security could become hard to value or to sell at a desired time and price, increasing the risk of investment losses.

Risk rating

Share

Important message