Yet despite the broadly supportive technical backdrop of reasonable demand and subdued issuance (year-to-date net issuance in Europe remains below the levels seen over the same period in 2018, although US high yield gross and net issuance is higher) there has been a reluctance on the part of investors to drive credit spreads aggressively tighter. The chart below highlights how the decline in yields on global high yield bonds has been heavily influenced by a rates effect (the decline in equivalent government bond yields). The yield has declined from 7.5% (750 basis points) in December 2018 to 5.9% in June 2019 yet spread narrowing accounts for only 100 basis points of the 160 basis points fall.
In fact, if we take the difference between the yield and credit spread as a proxy for the rates effect we can see that rates have been helping to offset spread widening episodes in Q4 2018 and May 2019.
These spread widening episodes bring us back to our opening analogy on how long the economic expansion can continue as they each correspond to growth scares: Q4 2018 reflecting concern that the Fed was making a policy error by overtightening; and May 2019 reflecting fears that trade war escalation would push a weakening global economy over the edge.
Policy easing returns
The U-turn by central banks towards additional policy easing needs context. It is only taking place because economic data has weakened. The Trump tax stimulus is fading, business confidence and purchasing manager indices globally are declining, and manufacturing, particularly autos, is feeling the combined impact of a slowdown in China and industry disruption. To be fair, employment levels and wage growth have been robust but these tend to roll over later in response to prolonged weakness at the corporate level.
What is astonishing is that the US Federal Reserve has altered course over the summer without significant market weakness. This may tell us one of two things. Either it is genuinely concerned that the economic weakness is structural and that the US/global economic expansion has reached its limit. Or, it is acting pre-emptively in the belief that this is simply a mid-cycle slowdown and that early action can extend the cycle.
In pledging “to act as appropriate to sustain the expansion”, the Fed is joined by the European Central Bank (ECB) promoting further policy easing and central banks as far afield as Australia cutting rates. There is also increasing support for fiscal expansion, framed by politicians with an eye on growing populism. Taken together, accommodative monetary policy and greater government spending should extend the credit cycle.
Against this backdrop global high yield fundamentals are reasonable in both the US and Europe. Interest coverage remains high relative to history, despite some deterioration in the US. We expect leverage to head higher in 2019 as earnings soften and the deleveraging which has been taking place within the energy sector since its crisis in 2015 begins to fade. Leverage levels do not look excessive, however, and with the backdrop of easier policy should create the conditions for spread tightening.
Gross leverage levels in high yield
Source: European gross leverage – Morgan Stanley Research, Bloomberg, using a sample from the European iBoxx HY index, as at 31 December 2018. US gross leverage – Credit Suisse, Credit Suisse Liquid US High Yield Index as at 31 December 2018. Gross leverage = Total debt/EBITDA (earnings before interest, tax, depreciation and amortisation).
In such circumstances, we see better value in European high yield compared with US high yield. This is because at a ratings-adjusted level the European market offers more attractive spreads in absolute terms and in terms of the gap between current levels and recent tights (lows). The risk of a rate rise from the ECB is also smaller and the likelihood of corporate bond purchases greater – both of which should help drive spreads tighter.
Europe and US high yield single B rated credit spreads
Source: Bloomberg, ICE BofAML European Currency High Yield B Index (HP20), ICE BofAML US High Yield B Index (H0A2), 19 June 2015 to 19 June 2019. Libor option-adjusted spread.
Yet, the longer the cycle extends, the more likely that bondholder-unfriendly late-cycle behaviour builds. While the high yield sector has actually been better behaved than the investment grade sector this year in terms of a higher proportion of primary use of proceeds going towards debt refinancing and repayments (75% of US high yield compared to just 30% of US investment grade*), the prospect of looser policy could undo this. Meanwhile the build-up of leverage in investment grade risks a flood of downgrades into high yield.
*Source: Dealogic, Goldman Sachs, year to date use of proceeds, 18 June 2019.
Looking at the European high yield bond market to mid-May we can see a marked dispersion in returns.
Dispersion of returns within European high yield
This was, in aggregate, a period of positive returns for high yield. A move from risk-on to a risk-off environment could easily see similarly wide dispersion but with a negative return bias. We believe that global high yield will attract investors in coming months, but geopolitical concerns, rising corporate costs, fragility in economic data and the effects of disruptive competition on individual credits means it is worth building some defence into a portfolio. In our view, this means engaging in ‘quality control’, not necessarily in terms of higher credit ratings but in identifying issuers where directional improvement in cash flows and balance sheets is evident.