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European High Yield: the income generator

Valuations in European high yield may have become less attractive after consistently strong performance in recent years. But with Europe's economy gaining traction, corporate balance sheets looking healthy and leverage significantly lower than in the U.S., Europe's high-yield bonds look primed to offer a relatively stable source of income over the next couple of years.

A decade has passed since the start of the financial crisis, and finding a safe source of income is still a formidable challenge. Despite this, we believe European high-yield bonds will be an attractive option for stable, risk-adjusted yield.

The key factor in our thinking is that default rates are forecasted to remain at all-time lows. Credit-ratings agency Moody's forecast a 2.3% default rate for European high-yield debt this year, down from the current trailing rate of 2.8%. Low defaults equate to low volatility, and there is reason to think this will continue.

A bond defaults for one of two reasons. First, an issuer can't pay when the debt becomes due, either because it doesn’t have the cash or can't borrow the money. Second, an issuer is unable to service prevailing interest payments on its debt. Currently, borrowing costs in Europe are at rock bottom and, while they will eventually increase, they appear set to stay low for some time. This substantially improves solvency ratios at a market level.

On average, a European high-yield company can refinance its debt today at a third of the cost it would have had to pay five years ago. Refinancing risk is also low by historic standards. The debt maturity profile of the market is evenly distributed, with no single year representing a "maturity wall" and a spike of refinancing needs. Furthermore, lower-rated bonds represent less than 50% of the market’s refinancing needs over the next four or five years, which again reduces risk.

Elsewhere, government (sovereign) bond yields are still very low in Europe. This has forced investors to broaden their hunt for yield, driving demand for high-yield bonds. And, while the European Central Bank (ECB) will inevitably taper its quantitative easing (QE) program at some point, soft inflation readings of late has seen more dovish messages from ECB President Mario Draghi, relieving pressure on the central bank to scale back its bond purchases.

Strong demand and low defaults have compressed the difference (spread) between government and corporate bond yields. Today, the redemption yield of the European high-yield bond market is 3.2%, versus 10% six years ago. But this is set against a five-year German bund yield of -0.2%. We see this 3.4% yield spread as attractive in an environment where the high-yield default rate - in other words, the risk of crystalized loss - looks set to remain low. (All figures sourced from Bloomberg, July 2017)

Demand has certainly driven up bond prices. The neutral price (par capital value) of a corporate bond is 100. Investors currently have to pay 104, on average, to buy a high-yield bond. This causes capital depreciation over time. If an investor pays 104 for a four-year bond that offers 5% interest (coupon), they simplistically lose 1% a year in capital value over the life of the bond. But all things being equal, if they hold the bond until maturity, they still end up with an annual return (yield) of 4%.

Defaults matter

The most important question for investors to ask is: What might cause default rates to rise? We see some causes for concern but attach a low near-term probability to each.

The good news is that the main risk at the start of the year - political risk - has largely diminished on the back of Emmanuel Macron's decisive victory in the French presidential elections. The win helped allay concerns around what anti­ establishment candidate, Marine Le Pen, might have meant for markets. Instead, the banker-turned-president brings a renewed sense of optimism to the scene as he looks to implement his ambitious reforms with one of the strongest mandates in recent history.

That was the primary political hurdle to overcome. Italy remains in the spotlight with a general election looming in the coming year. The risk here lies behind the rise of the anti-European Union (EU) Five Star Movement, although the party's appeal is waning. Elsewhere, Britain's exit from the EU is looking like it could add some surprises. Considerable uncertainty over what Brexit will actually look like remains, although we see a messy Brexit divorce as ultimately unlikely; an acrimonious exit benefits neither side.

A second risk to higher defaults is the economy nosediving back into recession. But while it's been a slow and fragile recovery in Europe, the tide has firmly turned, and growth is back. The economy has just posted its fastest rate of growth since the eruption of the debt crisis six years ago.

Manufacturing is in the grip of a jobs boom, factories in France are hiring at their quickest pace since 2000 and Spain is growing at a rate not seen since the start of the monetary union in 1998, according to IHS Markit's purchasing managers' index. All this points to a much brighter outlook and underscores the improving fundamentals of the economy as well as the eased fears of a populist political threat. It also reduces the likelihood of default significantly.

Nothing good comes easy, and sometimes the best medicine is a bitter pill to swallow. Companies in Europe have endured a rough ride for a number of years, but it's made them stronger for it. With the economy on track, confidence is returning. And confidence breeds investment. Companies who were previously conservative with their balance sheets now find themselves leaner and more efficient than they were pre-crisis. This wave of optimism is already equating to more jobs and increased spending. In economic terms, it's the Keynesian multiplier effect.

The third and most plausible risk is that European growth exceeds expectations. While easy monetary policy is supportive in the near term, the central bank would err by leaving policy too loose for too long. This would drive up inflation and growth to a point where the ECB would have to act suddenly to tighten monetary policy. It would be the equivalent of slamming on the brakes when driving at 100 miles per hour, and it would cause a shock to markets. Stronger-than-expected growth could also lead to more aggressive lending behaviors and equity-friendly management, which can act as a signal we are entering the final phase of the credit cycle.

But the data points to a gradual economic recovery, suggesting the ECB can muddle through on growth and inflation. If it is able to tighten policy in orderly fashion, then markets will start to normalize. At that point, we would expect populism, which thrives on economic and social unrest, to lose steam.

Even if growth did surge up to 3% or more, we suspect markets would like that more than they disliked it, at least initially. Any negative side effects could take years to materialize, meaning bond holders would continue to enjoy a nice coupon in the meantime.

For the foreseeable future we see no grounds for record-low default rates to rise materially.

For the foreseeable future, we see no grounds for record-low default rates to rise materially. This supports our case that European high-yield bonds will provide a relatively stable source of income for longer-term investors.

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 may be enhanced in emerging markets countries.

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