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 US, Europe’s high yield bonds look primed to offer a relatively stable source of income over the next couple of years.
A decade on 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 prove hard to beat for stable, risk-adjusted yield over the next couple of years.
The key factor in our thinking is that default rates are forecast 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 we have reason to think this will continue.
A bond defaults for one of two reasons. Firstly an issuer can’t pay when a debt becomes due, either because it does not have the cash or can’t borrow the money. Secondly, an issuer is unable to service prevailing interest payments on its debt. Currently, however, borrowing costs in Europe are 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 markets 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 programme at some point, soft inflation readings of late has seen more dovish messages from 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 yield-to-maturity of the European high yield bond market is 3.2%, versus 10% six years ago. But this is set against a 5-year German bund yield of -0.3%. We see this 3.5% 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)
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 main risk at the start of the year – political risk – has largely diminished. First up were the Dutch elections in March, billed as a litmus test for populism in Europe. Markets watched the rise of Geert Wilders’ Freedom party but ultimately it was centre-right Mark Rutte’s VDD party that posted a resounding victory. Next up were the French general elections in April. Anti-establishment candidate Marine Le Pen had been making plenty of noise in the build up to the elections, but again it was good news for markets thanks to Emmanuel Macron’s decisive victory.
In the UK, Prime Minister Theresa May called a surprise snap election that was held in June. It was a political gamble which was supposed to have strengthened her hand ahead of Brexit negotiations. But the move backfired and Mrs May was instead left to cobble together a coalition government with Northern Ireland’s DUP party. Somewhat perversely, the result is likely to soften May’s hard stance to Brexit which will benefit markets.
Looking ahead, there is still considerable uncertainty over what Brexit will actually look like. A messy Brexit divorce as is ultimately unlikely, however, given an acrimonious exit benefits neither side. Italy also remains in the spotlight with a general election looming. The risk here lies behind the rise of the anti-EU Five Star Movement, although the party’s appeal is waning.
Moving away from the political scene, a second risk to higher defaults is the economy nosediving back into recession. It’s been a slow and fragile recovery in Europe but the tide has firmly turned and growth is back; the economy 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 careful 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. Additionally, we feel the conservative nature of European high yield companies will be a strong depressor of default risk over the short to medium term.
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 slamming on the brakes when driving at 100 mph, and it would cause a shock to markets. Stronger than expected growth could also lead to more aggressive lending behaviours and equity-friendly management, which can act as a signal we are entering the final phase of the credit cycle.
The data, however, 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 normalise. 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 materialise, 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. This supports our case that European high yield bonds will provide a relatively stable source of income for longer term investors.
The value of investments and the income from them can go down as well as up and you may get back less than the amount invested.
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