28Aug 2016

Ben Pakenham,
Senior Investment Manager,
Fixed Income - EMEA

European high yield: vigilance amid volatility

Some investors may be hesitant to add an asset class like high-yield bonds to their portfolios. After all, these securities are issued by companies with lower credit quality and may seem inherently risky, especially during times of uncertainty such as the aftermath of the Brexit vote.

However, high yield has been resilient in the weeks since the UK voted to leave the European Union (EU), particularly when compared against equities. We remain positive on the European high-yield bond market given central bank responsiveness, expectations that defaults will remain low and broadly stable fundamentals for high-yield issuers.

Accommodative central bank policies continue to be the primary driver of global financial markets. Spreads widened dramatically in the immediate aftermath of the EU referendum, and sterling-denominated bonds fared worse than those denominated in euros. Once it became evident, however, that there would be further stimulus where needed in both the UK and Europe, and that interest-rate hikes had been put on hold in the US and elsewhere, market conditions improved. Spreads have narrowed since and are now tighter for euro-denominated high yield than they were before the vote.

Loose monetary policy supports high-yield issuers, and for this reason we don’t anticipate a spike in bond defaults - a major indicator of the market’s health or otherwise. Default rates are also what ultimately drive investor returns. The recent reopening of new-issuance markets helps companies gain access to longer-term debt at attractive levels. With falling interest expenses and extended debt maturity profiles, the triggers for default are less obvious.

The European Central Bank’s (ECB’s) bond purchases, most notably of corporate bonds, also pushes investment grade buyers into the asset class in the search for yield. This substantial incremental demand creates a positive feedback loop for issuers as capital is both easily accessible and inexpensive. We see little reason to expect a meaningful deterioration in the earnings profiles of the majority of companies we invest in. Sectors with exposure to the UK consumer or those UK businesses with non-sterling costs may experience some short-term instability, but not to such a degree that we are expecting debt levels to become burdensome. Equally, there are issuers in the UK with external revenues that will benefit directly from the recent depreciation of the sterling. In continental Europe, for the vast majority of sectors, it is business as usual. There may be a slight short-term slowing of growth, which may have a bearing on equity returns, but from a debt perspective balance sheets remain conservatively levered and liquidity ratios are reasonable.

Given the factors mentioned above, we think the European high yield story remains intact. Growth expectations in the region are rightly being revised down as confidence, consumption, investment and trade flows will be affected in the short term. Nevertheless, the swift reaction from central banks has already calmed market nerves, even if up to this point there has been more rhetoric than action.

Primary markets have reopened to euro and sterling issuers alike, and interest-rate expectations have been extended globally. Default risk remains muted in Europe, with the ratings agency Moody’s forecasting a fall in the rate to 1.9% by year end. Having said that, as yields fall so will returns expectations. It is worth cautioning that while we believe income returns are well protected, we also see limited capital gain opportunities at these levels.

Important Information:

Fixed-income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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