The European high-yield market has rallied strongly in the last two years as the banking system has been stabilised and the outlook for economic growth has improved. Many investors are arguing that there is now limited upside in this market and I can see their argument. But investing in the European high-yield market is not about making a single call. This is now a large, diversified asset class that can offer investment opportunities across the market cycle to investors that able to analyse its constituents case-by-case, and take an active management approach.
The European debt market has been one of the undoubted successes of the euro project. A large, single currency market has developed to replace the relatively meagre, local currency debt markets that existed before 1999.
Today, European corporate bonds offer a more efficient means of local-currency funding for European companies and the chance to diversify their funding away from their traditionally heavy reliance on bank lending. It also enables larger-scale European currency funding for non-European corporates.
Development has been especially rapid in high-yield debt. Since the introduction of the euro, the pan-European high-yield market has grown from less than €5bn and 37 issues to €275bn and 590 issues.
European currency debt now constitutes over 20% of the global high-yield credit market, with issuers from more than 30 countries spread across industries and credit quality categories. Diversification has been increased further in recent years by issuers in peripheral eurozone countries who have taken advantage of improving investor sentiment to shift funding away from their still recovering domestic banks.
The market offers diversification at the asset class level too. The correlation of the monthly total returns of the BofA Merrill Lynch European Currency High Yield and German Government indices has been -23% since 1999, compared to a correlation of +52% between Bunds and the investment-grade constituents of the BofA Merrill Lynch Euro Corporate index.
The high-yield market displays a relatively wide dispersion of returns. Year to date, the difference in return between the average of the first and fourth quartiles is almost four times greater for European high-yield than for investment grade bonds (figure 2). This highlights the importance of active management. While many bonds have seen high levels of return in this period, even the continuing strong demand for the asset class has not prevented others from recording significantly negative returns.
There are other features of today’s high-yield market that put a premium on active management and security-level research.
Supply is high. Barclays estimates that €69.9bn of European high-yield debt has been issued across currencies in the year to the end of October, an increase of 45% on the same point last year. This already constitutes the highest calendar year of issuance in the history of the market, with two months still to go.
The bulk of this is for refinancing and general business purposes. With issuers typically paying a lower level of interest on new debt than on legacy debt, these refinancings are in aggregate lowering funding costs and so strengthening corporate fundamentals, a positive for the market. However, an increasing proportion of the debt being raised for paying dividends and for corporate transactions is increasing.
The rate of default remains low. According to Moody’s, the trailing European 12-month speculative grade default rate was 3.3% in the third quarter of 2013, down from 3.4% in the second quarter and 3.6% a year ago. But there are signs of deterioration in the corporate fundamentals of borrowers. The leverage of European companies issuing high-yield debt was 4.2-times in the first quarter of 2013, the highest level seen since 2009, according to JP Morgan. As Moody’s has noted, these issuers have less room to underperform on financial forecasts and will be more vulnerable to external shocks including weaker economic growth or changes in the interest rate environment.
The level of capital appreciation we’ve seen in the market is itself changing the market’s dynamics. The vast majority of high-yield bonds are now priced above par and it is estimated by Morgan Stanley that more than half of the market could be called by its issuers if they so wish. When a bond is trading above its call price, its upside is limited. Calls also reduce the yield of the market as higher yielding bonds are replaced with refinancing deals issued at lower rates. Finally, as bonds come close to or exceed their call price, investment managers must adjust their calculation of portfolio duration to account for the likelihood of calls, when their bond investment will be converted to a zero duration cash position.
A rising level of calls, in my view, is a sign of market strength, not weakness. It limits future upside but it reflects past gains. But it’s necessary to distinguish between callable and non-callable bonds and to understand the potential impact of these calls, again underlining the importance of research at the issue level so that investment managers can adapt to changing market conditions.
So there are definitely reasons to believe that there is limited capital upside in the high-yield bond market at current levels. However, this is not a monolithic market, it is a growing and increasingly diversified asset class. There are opportunities to invest in seasoned issuers whose bonds are yielding 5-7%. In today’s markets such investment options look attractive. But you have to be able to manage this asset class actively and choose securities carefully to find bonds that offer the best balance of reward for the risk.
Paul Read is co-head of fixed interest at Invesco Perpetual