Composition of markets
On average the composition of the European markets is higher quality. The European index has a larger percentage of BB rated companies (67% v 49% for the US and more fallen angels (35% v 15% for the US)1. Fallen angels are previously investment grade companies that have been downgraded to high yield, generally due to industry or company-specific problems, Research by Moody’s, which covered non-financial bonds between 1993 and 2013, suggests that there is a modestly higher chance of a fallen angel returning to investment grade status (a so-called rising star) than that of a similarly rated non-fallen angel.
1Source: Bloomberg, BofA Merrill Lynch Europe (HP00) and US (H0A0) indices and Europe (HPFA) and US (H0FA) indices at 30 April 2016.
Reflections on fallen angels
A feature we have to be careful about when investing in bonds that were originally issued as investment grade is that they often do not come with covenants (protective terms attached to the bond). If a company is experiencing difficulties, a potential lifeline is to issue secured debt that ranks above the non-covenanted bonds.
Another issue – although this is more a US phenomenon than a European one – is that the investor base often migrates with the downgrade so unless there are strict rules on not holding high yield debt, the investor that held a bond at BBB will often carry on holding it at BB. Since the bond does not necessarily lose its investor base, it avoids cheapening by a massive amount, although there does tend to be an initial fall in price as the investment grade investor base is larger than the high yield investor base. The bond may only really become technically cheap when it drops to B and a marked shift in the investor base occurs.
The energy sector makes up a small part – only 5.4% – of the European high yield market compared to 13.8% of the US high yield market2. This has meant that the European market is less vulnerable to the volatility in the price of oil. Energy sector concentration is also greater in Europe, with Gazprom and Petrobras accounting for two-thirds of the European energy issuance, whereas the US has a long tail of small issuers.
Fig 1: Oil price still far off recent highs (WTI US$/barrel)
Source: Thomson Reuters Datastream, 31 December 2013 to 30 April 2016, West Texas Intermediate (WTI) oil price.
Despite the bounce in the oil price from the low earlier this year, the price at the end of April (US$46/barrel) was still below where it was a year ago, let alone the price two years ago. Many of the weaker energy companies were formed three to four years ago and were able to borrow by putting on 3-5 year forward hedges that locked in prices for their output at around US$80-100/barrel. As these hedges expire, the cash flow of these companies is going to take a significant hit and they may struggle to roll over their debt. We are expecting to see growing numbers of energy defaults this year, so remain underweight energy in our high yield portfolios.
2Source: Bloomberg, BofA Merrill Lynch Europe (HP00) and US (H0A0) High Yield indices at 30 April 2016
For long-term investors, the heightened risk of default is the key driver of spread premia for high yield bonds. In terms of defaults, the US high yield default rate has steepened and is forecast to reach 5.6% in March 2017 according to Moody’s, up from 4.1% in March 20163.
In Europe, Moody’s is forecasting the trailing 12m default rate to reach 2.8% in March 2017, little changed from the March 2016 figure of 2.7%3. The three factors we have referred to earlier – central bank policy, corporate behaviour and composition of markets – mean that the European default rate should remain low both in historical terms and relative to the US over the next couple of years.
The 2016 Annual Default Study by Deutsche Bank was released on 11 April 2016. It revealed that to protect for default risk in a five-year cohort of bonds formed in 2011 and held between 2011 and 2015, investors would have required spreads of 38 basis points (bp) in BBs and 133bp in B rated bonds over this period. To put this in context, current European/US BB spreads are 320/381bp and B spreads are 595/605bp4, suggesting high yield bonds in aggregate are more than compensating for a moderate pick-up in defaults. Fig 2 shows where spreads are in a historical context.
3Source: Moody’s Default Report, 8 April 2016.
4Source: Bloomberg, 30 April 2016, option-adjusted spreads versus government bonds. European spreads based on HP00 and US spreads on H0A0.
Fig 2: High yield corporate bond spreads
Source: Bloomberg, BofA Merrill Lynch US (H0A0) and European (HP00) High Yield Indices, spread to worst to governments, 31 March 1996 to 31 March 2016
High yield bonds continue to look attractive and European high yield remains our most favoured area of global credit markets. Although yields and spreads have narrowed since the sell-off in February, they remain compelling in absolute and relative terms. Support additionally comes from the dovish attitude of the ECB and low levels of primary supply on both sides of the Atlantic.
The sharp moves seen in recent months, however, prove that fundamental strength alone is insufficient to drive returns in high yield, and that broader macroeconomic and political concerns can sway the market. The uptick in sentiment has brought inflows into the asset class but we recognise that this trend can easily reverse, which together with the relatively advanced stage we are at in the credit cycle, causes us to be cautiously positioned within our portfolios.