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IPE special report May 2018

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Euro high yield still in its infancy

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The European high yield bond market has experienced rapid growth over the past several years. The supply of high yield bonds has been driven by several factors including increased M&A activity, deregulation, explosive growth of the media and telecommunications industries, and accommodative capital markets. Demand was fuelled by the introduction of the euro, which eliminated arbitrage opportunities between government bond markets, as well as investors’ desire for higher yields.
On the surface, European high yield bonds appear to offer an attractive alternative to traditional government bonds; the combination of high current yields with capital appreciation potential is compelling. However, prudent investors should thoroughly understand the downside as well. This article addresses the European high yield bond market by comparing it with the US high yield bond market. We believe the European high yield market will develop into a permanent and important part of the European fixed income landscape over time. But for today, we believe the best way to capture opportunities from this asset class, while reducing risks, is to construct a “global” high yield bond portfolio incorporating a majority of US high yield bonds.
At over $650bn in par amount outstanding and well beyond its 15th year anniversary, the US high yield bond market offers significant issuer, industry and credit quality diversification. It is a mature market representing over 20% of all US corporate bonds outstanding. There are more than 3,500 issuers from more than 30 industries. Over 70 issues have $1bn or more in outstanding high yield debt.
By contrast, at the end of 2000, according to Chase Securities and Credit Suisse First Boston, the European high yield bond market totalled approximately $47bn in par amount outstanding – less than one tenth the size of the US high yield bond market. Moreover, at last count there were only 250 high yield issues in the market, and only 12 had more than $1bn in high-yield debt. Despite its much smaller size than the US high yield market, the European high yield market has experienced impressive growth over the past several years, hence strengthening investor confidence that this market will prove to be a credible and important part of the global high yield opportunity set over time (Figures 1 and 2).
Support for the rapid development of Europe’s high yield market is evident by the number of industries represented. Three years ago, only eight industries had high yield bonds outstanding; today, there are 25. Despite the broadening of the market, the media and telecom industries represent almost 60% of par amount outstanding compared with 30% in the US high yield market (Figure 3). Considering that media and telecom companies were some of the hardest hit last year, investors must be cognisant of how widely diversified their high yield portfolios are. Because the European high yield market does not yet offer the depth and breadth available in the US high yield market, it is more difficult to construct a broadly diversified portfolio. In a volatile asset class such as high yield, lack of diversification, in and of itself, makes the European high yield market more risky than the US high yield market.
Credit quality is another way to compare the two high yield markets. As Figure 4 shows, the European high yield market has more B rated securities and fewer BB rated securities than the US high yield market. As the market matures, the risk profile of the European high yield market should improve.
Another key difference between the two high yield markets is the lack of a natural long-term buyer base in Europe. A natural buyer base helps stabilise the market during times of correction. Last year was the first real correction in the European high yield market since its inception. The Chase European High Yield Index declined by 12.67% last year versus a decline of 5.68% for the Chase Global High Yield Index. The US high yield market has experienced four significant corrections in its history: 1989–90, 1994, 1998 and 2000. Value investors and CBO funds have been natural buyers during these periods of stress, which has helped support the market. With time, the European market should further develop a natural buyer base.
Despite differences between the European and US high yield markets in terms of size, diversity, credit quality, and stage within the business cycle, the two markets correlate well with each other at 0.89% for the five year period ending December 31, 2000 as measured by Credit Suisse First Boston. Until the European high yield market develops further, prudent investors would do well to consider the European market as an extension of the US market rather than establish a separate European allocation. A pure European high yield allocation will likely result in higher volatility than an allocation to the combined “global” high yield market.
It is useful to review the benefit of adding exposure to high yield bonds within a broader-based government, mortgage and corporate bond portfolio. As the accompanying table shows, high yield bonds correlate poorly with other fixed income investments. This is due in large part to the fact that high yield bonds are less sensitive to interest rate changes. As such, adding high yield bonds to a fixed income portfolio provides significant diversification benefits and has improved returns over time.
Although the European high yield market remains in the early stages of its development, it should develop into a very important part of the European fixed income landscape. Augmenting a US high yield portfolio with selected European names is fast becoming a popular topic among plan sponsors and money managers. This “global” high yield strategy is not only a prudent means of investing in high yield bonds, but will aid the development of the European high yield market.
Mark Vaselkiv and Kevin Loome are members of the T Rowe Price high yield team in Baltimore

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