European high yield bonds continue to offer a relatively attractive yield profile with strong credit fundamentals. Tepid economic growth in Europe provides favourable conditions for high yield corporate bonds, allowing gentle earnings growth alongside supportive central bank policy. We provide five key reasons to consider investing now in European high yield bonds.
5x Interest cover
Europe remains behind the US in terms of the credit cycle and as such has avoided the deterioration in credit fundamentals that is more evident across the Atlantic. In fact, European high yield interest cover has been improving. Earnings on European high yield can currently cover interest payments a robust five times, higher than at any stage in the past ten years, as earnings have grown and companies continue to refinance at a cheaper cost. Net debt has remained relatively stable over the past few years, registering at around two and a half times earnings.
Supportive interest cover and net debt on European high yield
Source: Deutsche Bank, Bloomberg Finance LP, 1 September 2016. EBITDA = earnings before interest, tax, depreciation and amortisation
4% average yield
Yields on government bonds and investment grade corporate bonds have tumbled and in many cases reside in negative territory, particularly at shorter maturities. This has highlighted the attraction of European high yield bonds, which we believe offer an attractive combination of yield and relatively low duration (interest rate sensitivity) in return for accepting credit risk. With the default rate among European high yield bonds expected to remain low – Moody’s baseline forecast is a rate of 2.5%* over the 12 months to August 2017, unchanged from today’s default rate – a selective approach should allow investors to capture an attractive yield without excessive risk. As the following chart illustrates, European high yield bonds offer a sweet spot in terms of yield of around 4%, which is a significant uplift over other European debt.
*Source: Moody’s default report, 9 September 2016
Sweet spot: yield to maturity of major fixed income asset classes
Source: BofA Merrill Lynch, Bloomberg, as at 31 August 2016, IG = investment grade, HY = High Yield. Euro Corp IG = ER00, UK Corp IG = UR00, US corp IG = C0A0, EM corp IG = EMIB, Euro HY = HPIC, EM corp HY = EMHB, US HY = HUC0, UK Generic 5yr Gilt, US Generic 5yr Treasury and German Generic 5y Bund
3 digit spreads
Triple-digit spreads offer further opportunity for yield compression. At more than 400 basis points over associated government bonds there is still plenty of spread compression that could take place within European high yield. What is more, the spread remains more than 100 basis points wider than the tights of 2014. The spread acts a cushion against any rise in yield on investment grade bonds while also allowing for potential capital gains from spread compression as a declining yield lifts bond prices.
European high yield spreads have been 100 basis points tighter
Source: Bloomberg, Bank of America Merrill Lynch European Currency Non-Financial 2 % Constrained Index spread, option-adjusted spread over government, 19 November 2012 to 31 August 2016
2 central banks
Two central banks in Europe are now actively engaged in purchasing corporate bonds through quantitative easing – the European Central Bank and the Bank of England. While these purchases are directed at investment grade corporate bonds there is a spill-over effect on high yield bonds as investors are “crowded out” by the central bank purchases. Both banks also extend a more relaxed definition than the wider market in terms of investment grade by only requiring one investment grade rating to be eligible, bringing some high yield bonds into the scheme. This comes at a time when net supply of European high yield has been shrinking in 2016 due to a dearth of issuance. High demand and limited/declining supply is typically a formula for rising prices.
Favourable technical backdrop
Source: Deutsche Bank, Markit, as at 31 July 2016. Chart shows EUR iBoxx HY Non-Financial issuance and redemptions €mn for each calendar year
1st ranked fund
The Henderson Horizon Euro High Yield Bond Fund is the number one performing European high yield corporate bond fund for the period since the fund’s launch on 19 November 2012 to 31 August 2016. While past performance is not a guide to future performance, the team’s focus on early identification of improvement or deterioration in a company’s fundamentals has been instrumental in delivering success. The fund managers Stephen Thariyan and Thomas Ross are supported by a global credit team that allows them to recognise external trends affecting European high yield bonds and to analyse under-researched areas of the market for value opportunities.
Morningstar EUR High Yield sector – cumulative return since fund inception
Source: Morningstar, comparison with the Morningstar EAA Euro High Yield Bond sector, 19.11.2012 to 31.08.2016, cumulative total return, net of AMC, in euro. Performance shows euro denominated funds only, excludes single country and sovereign bond funds, Henderson Horizon Euro High Yield Bond A2 Acc and comparable peer group share classes.
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 investors may not get back the amount originally invested.