Expect surprises in European high yield
Joseph Mariathasan assesses the European high-yield market at a time when political risks are set to dominate investors’ thinking
At a glance
• Political uncertainties are having an impact on the European high-yield market.
• Relatively more attractive loan rates make bond issuance less attractive for SMEs.
• What will issuance be like for 2017?
• Slow growth and rising government bond yields may be more important than political surprises.
The euro-zone faces several challenges this year, not the least of which are elections in the Netherlands, France and Germany, where populist parties are threatening to cause Brexit or Trump-style upsets to the existing order.
The biggest influence is likely to come from France with the second round of the presidential elections, argues Rose Ouahba, head of the fixed-income team at Carmignac. There will be a definite impact on the high-yield market if Marine Le Pen wins the election: “She is very hostile to the EU, so French government bond spreads, currently at 50bps, would climb to 200bps. Some US funds are shorting French bonds.”
Such a prospect is not surprisingly causing much disquiet, particularly among foreign investors: “We don’t expect Marine Le Pen to win. But my clients are very afraid of that, Japanese clients in particular,” says Marina Cohen, high-yield portfolio manager at Amundi.
Carmignac also says that every US investor the firm has spoken to in recent months has asked about Le Pen and it gives her a 25% probability of winning the election. But Ouahba argues that the probability of a Le Pen victory is much lower than the markets appear to be pricing in. Moreover, even if she wins, she would not have a majority in the National Assembly, so there would inevitably be a coalition government, making it difficult for her to exit the EU: “I would put it as a tail risk with a 10-12% probability at most,” says Ouahba.
What the euro-zone high-yield market is suffering from is a lack of net new issuance. The supply in European high yield has been relatively low for a while, with very limited net euro high-yield supply in 2016, points out Thomas Ross, portfolio manager at Henderson Global Investors.
There has been relatively little M&A and most financings have been refinancings of existing debt. Ross does not see 2017 as being any different, leading to a negative net supply of high-yield paper. In 2014-15 a large number of companies refinanced out of loan markets into high-yield markets, but this is no longer the case. Based on demand from banks, CLOs and so on, and also differential valuations, Henderson sees companies refinancing out of public high-yield markets back into loan markets, which will further reduce supply in high yield, explains Ross.
One important factor he sees has been the impact of the European Central Bank (ECB) through the long-term refinancing operation (LTRO) by which the ECB provides financing to euro-zone banks. This has driven SME loan rates to all-time lows of 2% to 3%.
Moreover, while the level has reduced for companies in Germany and France, it has come down even more significantly for those in Spain and Italy. Ross argues that SME loan rates across Europe are now the same across Germany, France, Spain and Italy, whereas previously, they would have been higher in Spain and Italy. Because there are better refinancing rates for SMEs and CLO demand is still significant, companies are able to issue loans for CLOs at more attractive rates than issuing bonds.
Rating agency Moody’s sees four potential risks that could affect debt issuance over the next year.
• First, is the risk to the global financial sector from heightened volatility and possibly synchronous re-pricing of assets including equities, bonds and currencies when US interest rate rises resume. Moreover, Moody’s points out that the eventual tapering of quantitative easing (QE) by the ECB, provided that euro area economies continue to experience sustained growth and resilience, could also add to financial volatility globally.
• Second, the political and geopolitical risks of a rise in nationalist and protectionist pressures, which we are seeing already with President Donald Trump in the US.
• Third, the situation with the European elections. While Moody’s expects established political parties to prevail in most instances, it also argues that the potential for complex, fragmented coalitions and, in some cases, political surprises, is material. However, William Coley, senior vice-president and group credit officer for EMEA corporate finance at Moody’s, says the firm does not expect that the rising risks associated with European elections in 2017 will affect most high-yield corporate ratings, given the rating gap between them and the relevant sovereigns.
• Finally, there is also the background of geopolitical risks, especially from a potential diplomatic or military flare-up over sovereignty of the South China Sea or in the Syrian conflict, that may create negative market sentiment.
Despite the background risks, slow growth is the key theme for euro-zone high yield, according to Peter Aspbury, high-yield portfolio manager at JP Morgan Asset Management. This has been ideal for credit health: “We want to see positive growth but don’t want to see runaway risk-taking,” Aspbury says, noting that investors may be tempted to make imprudent assumptions on future defaults at this stage in the credit cycle when people are so desperate for yield. “We are not seeing that,” he says. “The leveraged loan market is doing a good job of taking on the more scary names. CLOs can accept lower spreads on loans.”
The credit outlook is very positive for Aspbury and he sees credit quality remaining high in Europe: “We don’t see runaway M&A, share buybacks or big dividend payouts. Risks are largely political, with sectors like the Italian banking sector facing large political risks.”
Moody’s supports this view, forecasting that the European speculative-grade corporate default rate will remain stable at around 2-3%. This is supported by generally stable credit quality trends throughout 2016, a large number of stable industry outlooks and moderate refinancing risk for the next two years. However, the firm does see the possibility of isolated defaults of companies vulnerable to event risk.
Whatever the political risks may be, investors still face the problem of high valuations: “We think [high yield] is relatively expensive,” says Cohen. “Spreads tightened 130bps in 2016. In Jan 2017, spreads tightened by another 25bps. So there has been more than 150bps of spread tightening in 13 months.”
Andrew Wilmont, European high-yield portfolio manager at Neuberger Berman, points out that valuations are also historically high because government yields are so low: “On a spread basis they are now starting to approach the tightest levels we saw in 2014, but still 80-100bps from the historical tightest levels we saw in 2007.”
As a result, Wilmount believes returns this year will be driven by coupon returns of 4%, with a lesser role for capital appreciation. If spreads tightened to 2007 levels, that would mean 3-4% capital gains. But government yields globally are expected to rise. Whatever one’s views of the impact of European elections over the next year, this may overshadow the risks arising from European political surprises.