Perspective

Five reasons to consider European high yield credit now


Historically low yields and scarcity of income are a stark and unwelcome reality for investors today, and have been one of the defining features of markets since the 2008 global financial crisis. While bond yields spiked far higher amid the Covid-19 crisis, the policy response and optimism around the recovery has seen them swiftly back down to low levels. 

Right now, we are in the midst of a forceful economic recovery, following the shock of 2020. This is welcome news for company fundamentals, among many other things. It does, however, introduce another challenge to bond investors, namely the risk of sudden jumps in yields, as in the early months of 2021.

Given the nature of these risks and opportunities, here are five reasons we think high yield corporate bonds are well placed.

Rare source of income

European high yield remains a rare source of income return, with compelling carry (yield or income above lower risk bonds), but with relatively low duration risk, which is sensitivity to changes in interest rates. 

This is particularly relevant given the reflationary pressures resulting from the reopening of economies, and potentially sharp, short-term rises in yields, as in Q1 2021.

The overall euro high yield market currently yields 2.5%. Relative to history this is not especially high, but we should consider about 20% of global bonds yield less than zero, with an aggregate global bond yield of 1%, and just over 0% for European government bonds.

The duration, which indicates how much prices will rise or fall for each 1% move in yield, of euro high yield has averaged 3.7 since 31 March 2020, compared to 7.3 for global fixed income. Bonds with higher duration will see a bigger loss when yields rise suddenly, and vice versa.

In Q1, US Treasury yields lurched higher as the US passed a large fiscal stimulus bill, fuelling already rising growth and inflation expectations. This led to one of the worst quarters on record for US government bonds, with the impact spilling over to investment grade corporate bonds. This highlighted the risk from high duration. 

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Economic upswing

The economic disruption caused by the Covid-19 crisis was enormous and the effects will be felt for some time. Here and now, with vaccination programmes progressing, we are at the start of a synchronised and pronounced cyclical upswing in growth across developed markets. The US is expected to grow 6.5% this year, the eurozone 5% and emerging markets over 7.5%.

High yield corporate bonds tend to benefit from favourable economic conditions. The increase in revenues, earnings and, in the case of listed companies, share prices supports deleveraging of corporate balance sheets. Both downgrade and default cycles have now peaked. With deleveraging and the improvement in fundamentals, we would expect to see net upgrades from here.

Valuations                           

High yield valuations look favourable, particularly relative to investment grade. The breakeven level, the amount that yields or spreads would have to rise for investors to suffer a loss over a given 12-month period, remain compelling in the context of solid and improving fundamentals.

Additionally, the ratio of the yield on BB to BBB European credit is elevated in the context of the past few years. 

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Under-researched, niche areas and recovery potential

We believe that the high yield universe is under-researched when compared with investment grade equivalents. Many high yield issuers are private companies and not listed on a public stock exchange. This increases the chances of securities being mispriced and means it is possible to uncover opportunities through deep analysis.  

In addition, the Covid-19 crisis hit some sectors a lot harder than others, and we can see that for some the yield remains relatively high. This suggests there is still some recovery potential in some areas and individual companies.  

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Central bank support

The European Central Bank (ECB) continues to hold deposit rates at negative levels and purchase investment grade bonds in the open market. In effectively keeping yields pegged at lower or near-zero levels, this is creating a highly supportive technical backdrop for high yield. It essentially ushers investors towards areas where there is more income on offer.

It also means companies can issue bonds at low yields and reduce their overall interest burden. The risk with this is that it becomes too easy to issue debt. Companies may end up taking on too much, meaning they could face risks if rates increase in future.