High yield (HY) markets globally have performed strongly year-to-date, energised by recent dovish central bank policy and a resurgence in risk appetite following lackluster returns in 2018. In a world with $14 trillion of negative-yielding bonds (according to Bloomberg Barclays indices), it is clear that demand for income-producing assets remains high.
European high yield also has delivered strong returns despite slowing growth in the region, the deterioration of corporate fundamentals, and rising idiosyncratic risks. So what has changed? More so than in other regions, it is clear to us that European HY markets are in the midst of a tug of war between these weakening fundamentals and strong technical forces including net negative supply, the pending resumption of corporate bond purchases by the European Central Bank (ECB), and a search for yield which is perhaps more acute in Europe than anywhere else.
We believe investors should focus on the parts of the market that can weather slowing growth as well as a future market environment where technicals may be less frothy. We have a preference for credits with lower cyclicality, preferring domestically exposed companies rather than exporters, and emphasize the importance of active management in order to avoid inadvertent exposure to defaults and idiosyncratic risks.
Weakening fundamentals underscore the importance of being selective
By virtue of their higher debt levels and the lower margin of error in managing their operational and balance sheet risks, high yield issuers are naturally more exposed to broader macroeconomic trends. The export-orientated European economy has been slowing as the ongoing trade war coupled with political uncertainty have helped place a brake on growth. As a result, we expect GDP growth in 2019 and 2020 to be anchored around 1%, putting pressure on margins already under threat from rising input costs and higher wages.
In that context, the fundamentals for European HY issuers are becoming less favourable, although the higher-quality nature of the market versus U.S. high yield may provide some protection against these risks (70% of European HY is BB rated versus 49% in U.S. HY, per data from ICE BAML). While defaults remain very low by historical standards (1.1% over the last 12 months, according to Moody’s), they have recently begun to rise once again, and the market will increasingly price in these risks where they exist.
Meanwhile, other measures of credit fundamentals such as net leverage have also been deteriorating in Europe, in contrast to the U.S. where leverage has been stable/declining as a result of the focus by high yield issuers on deleveraging and a macroeconomic environment that has given them greater flexibility to execute on that.
Strong technicals are keeping the market well-supported
In contrast to the more fragile fundamentals, technical factors – both supply- and demand-related – are helping to keep the European HY market well-supported.
Over the past four years, the European high yield market has been shrinking as a result of declining levels of net new issue supply, in part as issuers have been gravitating to the loan market instead, and in part due to a number of larger ex-investment grade issuers that were downgraded in the past being upgraded back to investment grade (see Figure 1).
Figure 1: The shrinking European HY market
While constrained supply has been a multi-year trend, demand for high yield assets has sharply accelerated this year, further fueling price momentum. This is largely the result of three factors:
- First, inflows have resumed back into the asset class as risk appetite returned to markets following the more dovish central bank “pivot” in the earlier part of the year.
- Second, and following the aforementioned dovish pivot, yields have rallied to such an extent that approximately 25% of the European investment grade credit (IG) universe now trades at a negative yield, and recently the total was nearly 50% (see Figure 2).
- Third, the ECB recently announced a new, open-ended, €20 billion-per-month asset purchase programme. While the ECB does not publish targets for the various underlying programmes, most market participants expect corporate bond purchases (CSPP II) to total approximately €4 billion per month.
Where we see value in European HY
While we are comforted by HY technicals, we are positioned conservatively in European HY portfolios in order to take advantage of future pockets of volatility.
With technicals trumping fundamentals, the rally in European HY this year has benefited BB credit where traditionally IG-oriented investors feel more comfortable. As a result, BB valuations have become more stretched but they are likely to remain so due to CSPP II.
Single B credit has meanwhile lagged the spread rally due to inherent idiosyncratic risk and high single-name dispersion. This offers opportunities for credit selection, and it is here that we are focusing on opportunities to add select credits with positive potential catalysts such as M&A, and lower cyclicality – preferring senior secured bonds and domestically exposed companies rather than exporters who are more vulnerable to global trade tensions and geopolitical risks.
Finally, we also caution against gaining exposure to the asset class via passive vehicles where investors take exposure to the full market, including those issuers where idiosyncratic, market and default risks are greatest.
To find out more about our views on HY, please visit our website at pimco.co.uk.
David Forgash is a portfolio manager in the London office and head of high yield investments for Europe.