FLASH
What now for European high-yield bonds?
Pictet Asset Management I July 2014
For professional investors only
There are not many asset classes that have delivered returns that can match
those of European high-yield bonds in the past five years. The market has gained
roughly 16 per cent per year since 20091, benefiting from central bank stimulus.
But with yields on sub-investment grade bonds having fallen to a record low of
sub 5 per cent at a time when the US Federal Reserve is withdrawing monetary
stimulus, some investors are worried about valuations.
Their concerns look well-founded - but only up to a point. While European
high-yield debt is unlikely to repeat the performance investors have become
accustomed to over the past five years, we believe there are many reasons why
they should maintain a strategic allocation to the asset class.
• Investors in European high yield bonds
are worried about valuations as the
US withdraws monetary stimulus
Benign economic climate
• Risks abound but there are many
reasons to retain a sizeable allocation
to non-investment grade debt
The European Central Bank’s decision to increase monetary stimulus has gone
some way in underpinning the region’s bond markets. Low interest rates, modest
economic growth and weak inflation make for a benign climate for high-yield
bond investors - the asset class has historically fared well in such conditions.
• The ECB is set to provide additional
monetary support, bond yield spreads
remain attractive and the asset class’s
credit standing remains strong
Persistently low interest rates have kept a lid on company borrowing costs,
making it easier for high-yield issuers to both meet coupon payments and extend
the maturity of their debt obligations.
Default rates have fallen as a result. Moody’s recently lowered its default rate
forecast for European high-yield borrowers for 2014 to just under 2 per cent, well
below the historical average.
The improvement in the credit standing of high-yield companies is evident
elsewhere. Credit rating upgrades now outnumber downgrades for the first time
since 2011 while, on measures such as net leverage and cash holdings relative to
total debt, speculative grade companies have made some good progress in recent
months. Cash-to-debt ratios among European high-yield companies’, for instance,
are now close to 35 per cent on average, compared with 30 per cent a year ago.
To the sceptics, these positive trends are already discounted by the market. A sub
5 per cent yield, they argue, suggests all of the good news is in the price.
But the absolute yield does not give the full picture. Yields might be low, but the
spread offered by high-yield debt – the extra compensation given to investors to
bear risks such as the threat of default – remain well within historical bounds.
Indeed, by our calculations, non-investment grade bond spreads have been lower
than the current level of 350 basis points about 20 per cent of the time since 2000.
A more diversified asset class
1
Returns for Merrill Lynch EUR High Yield Index
30.06.09-30.06.14, in EUR terms
There is also a structural aspect to the investment thesis. European corporate bond
markets are expanding at an unprecedented pace as bonds are replacing loans
as the funding vehicle of choice for a broad array of companies. This process of
disintermediation has had an especially profound effect on the high-yield sector:
with bank loans drying up, high-yield bond issuance has been increasing at a
yearly rate well into the double digits. The volume of bonds outstanding has
grown from just over EUR100 billion in 2007 to almost EUR400 billion. The asset
class’s expansion has gone hand in hand with an increase in its diversity – this year
alone, the market has played host to 40 debut issuers from a variety of industries.
1 | WHAT NOW FOR EUROPEAN HIGH-YIELD BONDS? | JULY 2014
Counter-intuitively, perhaps, this has not led to a decline in the overall credit
quality of the asset class; in aggregate, the credit profile of the high-yield market
has improved. This is partly thanks to the fact that Europe has become home to an
unusually high number of ‘fallen angels’ – companies that were once investmentgrade but have recently been downgraded to high-yield.
Risks remain
This is not to say risks have disappeared. As the problems at Portugal’s Banco
Espirito Santo show, the euro zone has more work to do to shore up its banking
system. The reforms it requires to place its bank and public finances on a more
solid footing may prove tough to implement. Another threat may emerge in
the primary bond market - low borrowing costs could result in increased bond
issuance from companies with chequered debt histories.
INVESTING IN EUROPEAN HIGH-YIELD
BONDS AT PICTET ASSET MANAGEMENT
• PAM offers two distinctive European
high-yield bond strategies
• Pictet-EUR High Yield offers access
to the broadest possible range of
euro-denominated speculative-grade
bonds
• Pictet-EUR Short-Term High Yield invests
in short-maturity euro-denominated
speculative-grade bonds
Pictet Asset Management Limited
Moor House
120 London Wall
London EC2Y 5ET
www.pictetfunds.com
www.pictet.com
Market liquidity is another potential trouble spot. With regulations forcing banks
to cut down on fixed income trading, the market intermediary function has
suffered some damage. This may limit investors’ ability to trade bonds in the
secondary bond market; bouts of volatility may become more frequent.
The portfolio managers of our Pictet-EUR High Yield and Pictet-EUR Short Term
High Yield bond funds are looking to mitigate these risks in a number of ways.
First, they are limiting investments in new bond issues. Only one in three new
issues currently are added to portfolios. Second, they have limited investments in
the riskiest areas of the market; the funds’ holdings of triple-C rated debt is less
than 10 per cent of total assets.
Notwithstanding these risks, the outlook remains encouraging. With the credit
standing of speculative-grade companies as healthy as it has been for some
time, and with euro zone monetary policy to remain looser than that of the US,
investors remain amply compensated for the risk of default. In a period when
income-generating investments are in short supply, that should be reassuring.
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