Oceans apart - US versus European high yield bonds

20/07/2016

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In this High Yield Insight we examine the differences between the US and the European high yield bond markets. Having credit teams based on both sides of the Atlantic, Henderson is in a strong position to assess the nuances of the two regional markets. This Insight shares some of our observations and the implications for investors.

Origins of the market

The high yield bond market has its origins in the US where there has been an identifiable market for sub-investment grade bonds since the 1970s. Initially, the bonds were used to fund mergers or leveraged buyouts but as bonds were rolled over and refinanced companies began to view them as a source of capital to meet their growing business needs. The concept spread across the Atlantic and by the 1990s a liquid market in high yield bonds began to form in Europe, with the market growing rapidly post the financial crisis.

Factoring in the differences

While both markets are affected by similar factors, there are clear distinctions between the two. Market constituents, supply and demand, and the credit cycle mean that the markets do not always move in unison as the relative performance chart below clearly demonstrates. Understanding the differences and similarities between the markets can provide an edge within the asset class.

Relative performance of European high yield versus US high yield

Relative performance of European high yield versus US high yield

Source: Thomson Reuters Datastream, BofA Merrill Lynch European Currency High Yield Total Return Index/BofA Merrill Lynch US High Yield Master II Total Return Index, USD. 31 May 2010 to 31 May 2016.


The tables below set out the key differences between the two markets and how we take these into consideration in our portfolio management. All figures are at 31 May 2016, sourced from Bloomberg and relate to the BofA Merrill Lynch US High Yield Master II Index (H0A0) and BofA Merrill Lynch European Currency High Yield Index (HP00), unless otherwise stated. HY is sometimes used as an abbreviation for high yield. Yields may vary over time and are not guaranteed.

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Please note that you can click the arrow to the right of each table to display more information.


Market constituents

 USEurope
Size of Market $1,318 billion$419 billion

The US market is considerably bigger but the European market has had more momentum recently, growing by 75% in the five years from May 2011, compared with a 19% expansion for the US market. The growth in the European market is a response to greater confidence as participants become more familiar with the high yield market, together with corporate borrowers turning to bond financing as banks’ appetite to lend wanes in the face of stricter capital rules. Additionally, finance directors of companies seeking to borrow find the incurrence covenants (triggered when a company takes a specific action such as a takeover) in high yield bonds less onerous than the maintenance covenants (tested periodically so borrower has to maintain an agreed level of financial health) in senior bank loans. In total, US high yield makes up 22.5% of the overall US corporate bond market, a larger proportion than the European high yield market, which makes up 15.7%.

Market value of high yield (US$ bn)

Market value of high yield (US$ bn)

Source: Bloomberg, 31 December 1999 to 30 May 2016. Market Value in USD using BofA Merrill Lynch regional indices (H0A0, HP00).

Number of issues2,282712
Number of issuers1,010367

As the longer established market, the US has more issues and issuers. The new issue market in Europe has been surprisingly light in the first half of 2016 despite there being high demand for bonds, although as May has progressed into June, there has been a pick-up in companies coming to market. New issue trends in the both the US and Europe continue to favour a warmer reception for higher rated issuers; for example, in the US only 11% of new issuance year to date has been done by companies rated split B or triple C.

% of regional HY bond index issued by listed companies82%68%

*Source: BofA Merrill Lynch Global High Yield Index, Henderson Global Investors calculations, at 31 May 2016.

The US tends to have a higher number of issues attached to companies with a stock market listing. An equity-market listing can be beneficial in two ways. First, an existing stock market listing offers an easier opportunity for a company to issue equity capital if it gets into difficulty, potentially increasing the buffer before there is a call on bond investors’ capital. Second, the stock price can offer an additional avenue for bond investors to gauge sentiment towards a company.

Top 3 sectors
Energy13.6%
Basic Industry12.7%
Media11.0%
Banking17.6%
Basic Industry13.2%
Telecoms10.2%

The high weighting of energy in the US market means it has been more affected by the volatility in the oil price and this is echoed in the higher default rate for the US. The energy weight in Europe is just 5.6% and is concentrated in a few large overseas companies that have issued bonds in euros, such as Petrobras, the Brazilian energy company and Gazprom, the Russian oil and gas giant, whereas the US has a long tail of smaller energy issuers. This means the US market offers more of a high beta play on the oil price. In contrast, Europe has a high weighting in banking and telecoms, a legacy of downgrades of formerly investment grade borrowers.

Top 3 sectors (% of index)

Top 3 sectors (% of index)

Source: BofA Merrill Lynch regional indices, 31 May 2016.

 

Market characteristics

Yield7.4%4.6%

The US is higher yielding. In part, this reflects a higher yield on the equivalent government bond. The 5yr US Treasury is yielding 1.4% compared with -0.4% for the 5 year German Bund yield, representing a 1.8% yield differential.

Spread (B rated)602 basis points596 basis points

Spreads are not that dissimilar between the two markets, reflecting the fact that once the associated government bond yield is removed from the overall yields, both markets are trading in similar spread ranges. We have chosen to show the spread on B rated bonds since they sit in the middle of the high yield spectrum and have fewer of the distorting effects that are associated with the ends of the spectrum. For example, spreads on higher rated BB bonds can be influenced by appetite from ‘tourist’ investment grade investors dipping into high yield, while lower rated single C bonds often have a broader spread range, reflective of more distressed companies.

Duration4.33.5

Duration in the US is slightly higher because maturities tend to be a bit longer and this dampens the duration-reducing effect of higher coupons in the US. The longer maturities in the US are reflective of Anglo-Saxon markets that tend to be more comfortable with longer maturities.

Callable bonds as % of total HY bond count56%61%

A callable bond is a bond that can be redeemed by the issuer prior to its maturity. The first call price is typically par plus half the coupon, which gradually reduces over the life of the bond, although there has been a shift in this convention, with issuers sometimes demanding a shorter non-callable period (giving them more flexibility), but compensating the investor by increasing the first call price to par plus 75% of the first coupon.

If yields in the market have fallen substantially, there may be an incentive for the issuer to call the bond and refinance at a lower rate. This creates reinvestment risk for the investor so the coupon on a bond with a call option is normally higher than a non-callable bond. Callable bonds are a common feature of both markets so yield to worst (yield taking into account call options) is the preferred yield when looking at high yield bonds in both markets.

Ratings structure
% weight in BB
49.6%67.7%

In terms of ratings structure, BB is the most common rating across both markets although the BB weighting is higher in Europe. In fact, the rating in the European market has actually improved over the last five years, with BB making up 67.7% of the European market at the end of May 2016, compared with 59.6% five years ago. Europe also has a greater percentage of fallen angels (formerly investment grade borrowers) which has contributed to the bias towards a higher rating. The lower weight of BB bonds means that the US market tends to be more sensitive.

Ratings drift
= (issuer upgrades - issuer downgrades) / rated issuers*
-9.8%+1.0%

*Source: Moody’s May default report, 8 June 2016.

The European market is still experiencing more ratings upgrades in HY than downgrades, in contrast to the US. This is likely a reflection of where we are in the credit cycle as European companies remain in a deleveraging phase. Greater emphasis in Europe is therefore placed on identifying catalysts for upgrades whereas in the US a more conservative approach is adopted to avoid downgrades.

Ratings drift (%)

Ratings drift (%)

Source: Moody’s, 31 May 2011 to 31 May 2016.

 

Technicals

FlowsPositive ytdPositive ytd

Fund flows have been rocky in both markets with negative flows during the market sell-off in January/February 2016, but broadly positive since. Flows are positive to the end of May but down on the levels of last year.

The client base in the US has a heavier retail backdrop alongside a bigger high yield exchange traded fund (ETF) market and this can cause the US market to be more sensitive to flows, creating more market volatility. The negative press surrounding the freezing of withdrawals at a Third Avenue high yield fund in December 2015 in the US illustrated the sometimes febrile nature of the market and why liquidity remains a consideration.

Net supplyHigher due to fallen angelsFlatter than previous year

The US has seen a high number of fallen angels, which has led to positive net supply (gross supply minus redemptions) in the first five months of 2015. In contrast, in Europe, gross supply in the first five months of 2016 has been broadly half that seen over the same period last year, with net supply positive but lower than 2015. The flatter supply but moderately positive fund flows is creating a positive technical backdrop for high yield in Europe.

Monetary backdropAccommodative (tighter)Accommodative (looser)

The US Federal Reserve is seeking to normalise monetary policy by moving away from emergency low rates. Although this process is slow, it does mean that debate about US interest rates is focused on a tightening of policy. High yield bonds are unusual in fixed income in that they can respond positively to rising rates if the rise is seen as signalling economic strength and better credit conditions.

In contrast, the European Central Bank (ECB) continues to pursue very loose monetary policy, with interest rates more likely to be lowered than raised. The Corporate Sector Purchase Programme (CSPP) is also leading to additional demand for investment grade bonds and we expect this to have a ripple down effect on demand for high yield bonds. This has led to an interesting phenomenon in which central banks are moving in different directions but both conditions could be positive for high yield – gently rising rates suggesting stronger economic conditions in the US, while unconventional policy by the ECB is backstopping demand in Europe.

Credit cycle

Default rate*5.0%2.7%

*Source: Moody’s May default report, 8 June 2016.

The US high yield default rate is higher, reflecting difficulties in the energy and metal and mining sectors. Some 60% of defaults so far this year have come from resources companies. It is also important to have an understanding of expected recovery rates as there may be value in bonds trading below par.

Corporate behaviourLate cycleMid to late cycle

US companies are exhibiting more late cycle behaviour such as borrowing to finance dividends to shareholders. Net leverage is climbing in the US, although much of the deterioration is due to weakness in energy and mining. In contrast, borrower behaviour among European issuers is still relatively restrained with proceeds from bond issues still largely going towards conservative refinancing

Leverage levels (Net debt/EBITDA) in HY credit

Leverage levels (Net debt/EBITDA) in HY credit

Source: Deutsche Bank, net debt/ earnings before interest, tax, depreciation and amortisation, December 2005 to December 2015.

 

Summary

The distinctive character of the two markets means it is not enough to look at one factor in isolation. Within our portfolios we see value in underlying credits in both regions, so that while the US offers a more generous yield environment, the earlier position in the credit cycle for Europe acts as a counterweight.






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.

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Anything non-factual in nature is an opinion of the author(s), and opinions are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its us.


Important information

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

Janus Henderson Horizon Euro High Yield Bond Fund

Specific risks

  • 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

Janus Henderson Horizon Global High Yield Bond Fund

Specific risks

  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • 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

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