Transcript European High Yield

For professional investors and financial advisers only – not for use by retail investors
European High Yield
Fund Manager Interview
March 2016
In such uncertain conditions, preparation
is key and investors should ensure their
portfolios are properly diversified. European
high yield cannot escape the short-term
global volatility but the power of the high
coupon asset class is weathering the storm
better than most so far, making it a strong
diversifier for fixed income portfolios.
%
500
450
• The weaker euro should benefit
European high yield
400
• The default rate remains low
300
350
250
200
150
European high yield
Bunds
MSCI emerging market Equity
EUROSTOXX
S&P500
European investment grade corporates
Past performance is not a guide to future results.
Source: Bloomberg, RIMES; Returns in local currency to 31 December 2015.
2015
2014
2013
2012
2011
2010
2002
100
50
2009
• US high yield underperforms European
high yield
meaning that lower commodity prices are
beneficial to profit margins in the region.
Furthermore, minimal maturities and a
cash-rich investor base, lends technical
support in a market where new issue supply
has disappointed.
Attractive long-term total returns compared to other asset classes
2008
• European high yield has held
up relatively well amid intense
market volatility
2007
Key points:
2006
Senior Investment
Manager
2005
Ben Pakenham
With the recent interest rate rise by the US
Federal Reserve (Fed) still fresh in investors’
minds and the added issue of slowing global
growth, financial markets are more volatile.
Most major equity indices posted returns of
-10% at the beginning of the year. However
European high yield indices held up relatively
well with returns of -2%. The Eurozone is
no exception to the volatility but growth is
still good enough for the bulk of high yield
companies to continue to be able to service
their debt obligations, and at a level that
encourages conservative behaviour from
management teams. European high yield also
has minimal exposure to emerging markets,
oil, energy and commodity sectors –
2004
Head of European
High Yield
There’s been a lot of market turmoil
recently. How has European high yield
dealt with the volatility?
2003
Steve Logan
High yield is a low duration asset
class, that is, it has slow sensitivity to
interest rates – what are the benefits
of this in the current market
environment.
is therefore set to accelerate over the next
two years, but not to levels that are likely
to cause overheating, inflation or aggressive
corporate activity – all in all, a decent
backdrop for credit.
Interestingly, worries about duration have
faded a little. That was a topic that was a big
discussion in the first half of 2015, particularly
in Europe where we saw a big back-up in
government bond yields. Stubbornly low
inflation, not helped by continuously falling
commodity prices, is also part of the equation.
Longer term, though, we continue to favour
a shorter duration strategy (2.6 years versus
3.5 years for the market) because we find it
hard to believe government yields can remain
this low in Europe forever. If quantitative
easing (QE) is ultimately successful in driving
inflation higher then you want to avoid being
too exposed to government bond risk.
What advantage does European high
yield have over US high yield?
production side. This is one of the key reasons
the US has struggled for the last two years.
The other point to make is that the average
duration of US high yield bonds is about a
year longer than in Europe, making US
high yield more sensitive to Government
bond movements.
Finally, Europe and the US are at very different
points in the monetary policy cycle.
The US has finished QE and is now tightening
monetary policy whereas the ECB have taken
rates into negative territory and have now
extended their bond buying programme
(and are likely to extend further).
European high yield is a very distinct asset
class. It’s quite easy to group high yield in one
basket, but actually today, more than ever,
we have seen correlations between the two
diverge. Over the last three years European
high yield has broken away from the US and
global high yield markets.
The relative tightening of monetary
conditions, along with increased pressure in
the energy sector, should cause default rates
to tick up in the US before they do in Europe.
Today, European high yield is lower yielding
than its US counterpart, but with that also
comes lower risk. Specific tailwinds that don’t
necessarily apply to the US market, such as
currency depreciation, have been helpful
for several of the companies that we invest
in, particularly those with external revenue
streams. For large commodity importers,
falling prices have been helpful both for
corporate margins but also for consumer
disposable incomes. Finally in Europe, there
exists a very accommodative central bank,
which again, is quite different to the
US market.
Should we be worried about
‘Third Avenue?’
Some commentators fear that the failure of
the Third Avenue US High Yield Bond fund is
indicative of further problems for high yield
credit. We don’t believe this is so. This fund
was heavily invested in illiquid positions
and was not representative of the broader
high yield market. Looking forward, we see a
number of positives for the asset class.
For example, the lower oil price, weaker euro
and further stimulus from the European
Central Bank (ECB) should continue to
provide a boost to economic activity. Growth
What does the decline in the value of
the euro mean for European
high yield?
A weaker euro should be perceived as a
benefit for the majority of European high yield
companies. For those companies that export,
it makes their goods and services cheaper for
overseas customers. For domestic consumers,
a weaker euro currency means the products
of domestic producers are more competitive.
Furthermore, a weaker euro encourages
tourism and inward investment, all benefiting
activity levels in the economy.
The yield difference between the two markets
is significant but there are good reasons for
that. The US has fewer banks but they have
a lot more oil and gas exposure (roughly
15-20%), particularly on the exploration and
Long-term asset class return correlations
EUR high
yield
%
USD high
yield
%
Investment
grade
corporates
%
10Y Bund
%
Euro Stoxx
%
Emerging
Markets
Bond Index,
Global
%
EUR high yield
USD high yield
91
Investment grade corporates
54
59
10Y Bund
(28)
(24)
39
Euro Stoxx
72
71
35
(33)
Emerging Market Bond Index, Global
70
77
76
8
56
S&P 500
69
74
33
(34)
86
Source: Merrill Lynch, Iboxx, JP Morgan, RIMES 31 December 2015. Correlations of monthly returns since 2005.
2
Fund Manager Interview - March 2016
60
S&P 500
%
Does European high yield correlate
with equities?
Return potential in a low growth
environment – while low global growth is a
concern, high yield companies do not need
robust growth to perform well. If anything,
low but consistent growth helps to promote
cautious corporate behaviour, which can
support the value of high yield bonds.
The extended period of low interest rates
has driven appetite for riskier assets such
as high yield and equities. Recently,
performance between the asset classes has
diverged significantly.
Downside protection – sub-investment grade
bonds have a comparatively higher coupon
component and shorter maturity profile than
other fixed income instruments. This helps to
lower the bonds ‘duration’ or the sensitivity of
the bonds price to a change in interest rates,
providing an element of downside protection.
All is not lost in the event of a default (as is so
often the case in equities) as the average bond
recovery is roughly 35 - 40 cents on the euro.
Why should investors include
European high yield as part of
their portfolio?
European high yield can benefit a wider
portfolio by providing:
Attractive income potential – in the current
low yield environment European high yield
bonds still provide a more attractive risk
return profile than the wider bond spectrum.
Bond coupons are contractual obligations,
unlike the payment of dividends which can be
easily cut.
Diversification benefits – high yield
bonds have a low historical correlation to
government and investment grade bonds.
Lower volatility than equities – high yield
bond returns have been similar to equities
over the past 25 years. The “pull to par” effect
and a high, stable coupon means that the
volatility of high yield bond returns has been
meaningfully lower than that of equities,
providing more attractive risk adjusted return
characteristics.
What is your outlook for defaults
in 2016?
We’re unlikely to see a systemic spike in
defaults as witnessed in 2009, but rather
periodic and correlated problems in certain
industries.
In short, default levels should remain
at the lower end of their historical range –
somewhere between 2-3%.
Company fundamentals are in decent
shape; earnings are stable and cash is being
generated. Furthermore (and to reiterate),
a lower oil price, low interest rates and a
weaker euro are all acting as tailwinds for
European companies.
On a longer-term basis, the fact that many
companies are refinancing bonds and locking
in much lower coupons means that even
when interest rates do rise, their ability to
service that debt will be enhanced. We believe
that this refinancing activity is will help to
keep defaults lower when the business cycle
eventually does begin to turn.
High Yield default rates
16
12
8
4
FY Default Rate - Europe
FY Default Rate - US
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
0
ForecastsC
Source: JP Morgan, S&P and Moody’s Investor Services, November 2015.
A contract that stipulates the terms of a formal debt agreement.
Bonds that were once of investment grade but has been reduced to high yield, or ‘junk’, status.
C
JPM forecast for the Europe in 2015.
A
B
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