Thomas Hanson, Co-Manager of the Euro High Yield Bond strategy, recognises that yields on European high yield bonds are near historical lows but believes that ongoing demand coupled with limited supply and a low default rate should maintain support for the asset class.
What lessons have you learned from 2017?
As active, fundamentally-driven investors, valuations will always form the cornerstone of our investment process, and this is particularly the case within the realm of high yield bonds. In European high yield, valuations have become more and more stretched as the year has worn on, resulting in all-time lows for the asset class in yield terms, and spreads testing levels not seen since before the global financial crisis. This has naturally led to a degree of caution in portfolio positioning. However, 2017 has offered ample evidence that other factors – and in particular the technical aspect of the market – can and will exert pressure on credit spreads that must be understood and factored into portfolio positioning. 2017 has served as a reminder that low yields and tight spreads do not act as an immediate impediment to lower yields and even tighter spreads.
What are the key themes likely to shape markets in which you invest and how is this likely to impact portfolio positioning?
Fundamentally, the outlook for European high yield credit is quite supportive at the moment, as we have an environment of low (but positive) economic growth across Europe, coupled with low inflation. Corporate fundamentals are robust in Europe, with companies so far having been reluctant to embrace higher leverage in the same way as some parts of the US market. This has led to a low default rate, underpinning the level of valuations in European high yield. Two key themes to look out for are the global unwind of central bank balance sheets, and the continuation (or otherwise) of technical strength (relationship between supply and demand) in European high yield. The tightening of ultra-loose monetary policy clearly has the potential to heighten volatility in markets, and although the pace is expected to be gradual and offset to some extent by supportive growth, it is unclear how this dynamic will ultimately play out. The technical strength of European high yield has been one of the most notable aspects of the market in recent years. The combination of several large issuers leaving high yield as they are upgraded to investment grade, with the continued popularity of bond-to-loan refinancing may ultimately lead to a more constricted high yield bond universe, which would add to the positive technical, all else being equal.
Where do you currently see risks within your asset class and where are the most compelling opportunities?
The main risk surrounds the tight level of overall valuations in the market, which leaves little room for error. In particular, the spread compression between single B rated bonds and BBs to historically tight levels is a concern, as investors may be indiscriminately reaching down in credit quality in order to pick up yield, resulting in a mispricing of lower-rated risk within the market. This relationship has already partially unwound in the autumn bout of weakness and may have further to run. Ultimately, high yield is a stock pickers’ market and as such we feel we are well placed to add value through rigorous bottom-up, fundamentally driven stock selection. Any rise in idiosyncratic risk, ie, those risks unique to individual bond issuers, is an opportunity for us given our active management style.
These are the manager’s views at the time of writing and should not be construed as investment advice.