There is much talk at present about the European high yield market and whether the supposed bubble is about to burst.
Investors have enjoyed a stellar five year performance since the financial crisis. The BofA Merrill Lynch European High Yield Constrained index returned 165%, outperforming the stock market by over 40% (FTSE World Europe index). Spreads on the BofA Merrill Lynch European High Yield Constrained index have tightened more than 1700 basis points to approximately 350 bps over the German Bund. After such a buoyant period it is hardly surprising that concerns are emerging about the future trajectory of the asset class.
In a recently published report, Aberdeen AM discusses these issues explaining why they believe the European high yield is not in bubble territory, but investors still need to be alert.
Though yields are at all-time lows and the asset manager expects returns to be more muted it does not adhere to the argument that the asset class is a bubble for a number of reasons.
Tight valuations are not the same as a bubble
Aberdeen AM believes there are fundamental reasons why spreads trade where they do. Default rates are low and they expect them to stay low. The majority of issuance continues to be used to refinance debt, which has allowed companies to borrow at lower interest rates and extend maturity profiles. Failure to refinance debt when it comes due or an inability to fund interest expenses are the two most common triggers for default. Aberdeen AM estimates 25% of the market is pricing to call by the end of 2015, which will bring the cost of debt down meaningfully for these companies assuming no great exogenous shock occurs. Furthermore, companies are increasingly preparing for or are rumored to be preparing an IPO later this year. This is generally a positive as it is a de-leveraging event (“equity claw” clauses in the docs) and provides a tangible equity cushion.
Spreads nowhere near all-time lows
In 2007 spreads fell to 179 basis points at a time when the market was lower quality and a quarter of the size. Aberdeen AM thinks, based on historical trends with spreads where they are there is room for further tightening. Having said that they believe this is more likely to come from rising government bond yields than capital upside as high bond prices and call options limit that. However, assuming defaults remain low there should be some ability for spreads to cushion government yield increases. Spreads primarily compensate investors for default risk and loss given default. The good news is that since 2010 nearly half of new issuance in European high yield (as of year-end 2013) has been secured, which means recovery rates going forward will be higher than they have been historically. This needs to be factored in when looking at what spreads are discounting in terms of default rates. Aberdeen AM is of the opinion that today spreads represent no worse than fair value when analyzing them in this way.
Correlation to government bonds is low
If there is a bubble the asset manager believes it is in government bonds which have experienced a 30-year bull run and have been artificially supported by quantitative easing. However, even if this is a bubble, they think it is unlikely to burst anytime soon. Given the anemic state of the European economy the European Central Bank is unlikely to raise interest rates any time soon. Eurozone unemployment is not expected to fall much below 12% this year, inflationary pressure is currently non-existent and the most bullish Eurozone growth forecasts cap out at 1.5% for 2014. Even when rates do start to rise, the effect on high yield may be somewhat limited compared to say investment grade. The average maturity in European high yield market is around four years; so relatively short-dated. The four year bund yields 0.4% so almost all the yield is spread which is a key reason sensitivity to government bonds is so low.
Outlook
Whilst Aberdeen AM is not anticipating a significant sell-off in European high yield the asset manager is certainly cautious and would view a period of consolidation or even a modest correction as healthy. In what is often a seasonally weak period for financial markets, the second quarter could offer better opportunities to top up positions in favored holdings. At the same time, they believe investors need to be watchful as lower quality companies continue to take advantage of the borrowing environment and bondholder protection from covenants erodes. Longer term, the maturity wall and interest rate expectations suggest 2017 could be when defaults begin to tick up. Between now and then there is the opportunity to possibly harvest a healthy income yield.
1 The BofA Merrill Lynch Euro High Yield Constrained Index contains all securities in The BofA Merrill Lynch Euro High Yield Index but caps issuer exposure at 3%. The BofA Merrill Lynch Euro High Yield Index tracks the performance of EUR denominated below investment grade corporate debt publicly issued in the euro domestic or Eurobond markets.
2 The FTSE All-World Europe Index is a free float market capitalization weighted index. FTSE All-World Indices include constituents of the Large and Mid capitalization universe for Developed and Emerging Market (Advanced Emerging and Secondary Emerging) segments. Base Value 100 as at December 31, 1986.
3 Source: Bloomberg
4 Source: Bank of America Merrill Lynch Research.
5 Source: Bloomberg and Dealogic.