What’s not to love about European high-yield bonds? A supportive central bank whose non-conventional monetary policy suppresses bond yields across the region, purchasing managers’ indices at a six-and-a-half-year highs, more upgrades than downgrades, a low default rate, improving economic fundamentals and strong technical factors.
A very unusual year for returns in European high-yield bonds
Thanks to those ingredients, European high-yield bonds have generated a return of 6.5% so far this year (to end October 2017), a little over twice that of European investment-grade bonds, but with only about two thirds of the volatility - see Exhibit 1 below.
Are high-yield bonds not supposed to be riskier than investment-grade bonds, not less? This is too good to be true, right? In this context, one wonders where we go from here.
Exhibit 1: Not what you would expect - returns and volatility of euro high-yield bonds (HY) and investment-grade (IG) bonds in 2017
Source: Data based on ICE BAML indices (returns to October 2017)
What happens next ?
Our view is that conditions are likely to remain supportive, certainly from a fundamental perspective. Default rates are expected to remain low, at about 1% in 2018. Companies are generally continuing to reduce their debt and – thanks to accommodative financial conditions – improve their cash flow with lower interest payments (see Exhibits 2 and 3 below).
And, with solid economic activity in Europe, companies should be able to find pricing power, allowing them to improve their cash flows and debt metrics. This should contribute to keeping the default rate low for the foreseeable future.
Exhibit 2: Leverage in European high-yield bonds does not appear excessive to us - graph shows changes in the level of issuer leverage (net debt/EBITDA)
Exhibit 3: The debt burden of European high-yield bond issuers does not appear excessive to us - graph shows changes in the EBITDA-to-interest coverage ratio
At some stage there will be a correction...
It is unusual that in 2017 high-yield bonds have been less volatile than investment-grade, and we think this will correct itself in time.
Just how long that will take is a difficult call, but the end of the ECB’s quantitative easing (QE) programme could provide a good starting point.
In our view, the mini sell-off in November 2017 is a sign that we are heading for that normalisation. It is difficult to point to one single factor that drove the repricing, but we think the significant sell-off in Altice’s share and bond prices following its profit warning was the catalyst. Expectations of future cash flows had disconnected from reality and the profit warning from this telecommunications conglomerate led to massive reductions in bond positions.
What started as an idiosyncratic situation quickly morphed into a general deterioration in sentiment and distrust for the most highly-indebted companies. Spreads on bonds by other higher-beta names widened in sympathy, while issuance by higher-quality companies held its value much better. Mutual funds and exchange-traded funds (ETFs) suffered outflows and for a while it looked like things could turn even uglier.
However, the market did stabilise; after all, investment managers have been conditioned to buy the dip and bargain-hunting helped bond prices find a floor. In the end, the sell-off was well contained and as long as there is no macroeconomic shock, one could even envisage a ‘Santa rally’ in December which could pave the way for healthy performance in January.
So, with everyone back in the pool, does the party now continue?
In the short term, quite possibly so. However, we think that over the medium term, the market needs to prepare for such moments of volatility and this process should change the composition of demand for high-yield bonds. Spreads have been compressed by about 100bp year-to-date (to the end of October 2017) and thus capital appreciation has contributed to 40% of the total return for the year, with the coupon contributing ‘only’ 60%.
There are visitors in the market for high-yield bonds...
Interestingly, high-yield mutual funds have on average experienced small outflows this year. This means marginal demand for high-yield has not come from traditional buyers, but rather from fixed-income investors who have ventured beyond their natural mandate to boost returns. In the process, and quite exceptionally, they have also reduced the volatility of their portfolios.
Since reality checks between market valuation and fundamentals are inevitable, we think even a measured increase of volatility in high-yield debt markets could prove too much for these investors to stomach when (and if) they experience these moments of market dislocation.
A shakeout could benefit investors with staying power
Such a shakeout should enable long-term high-yield bond investors to demand higher spread compensation, especially as we expect many high-quality BB issues to be upgraded back to investment-grade, leaving a smaller pool of high-yield bonds to pick from, with on average a slightly riskier profile.
In the end, we think long-term investors in high-yield debt will benefit from a stickier pool of money, higher spreads and – assuming German Bunds also ‘normalise’ at a higher level – from a better all-in yield. As long as the fundamentals stay in check, we can live with that and think this will provide opportunities for the active investor.
Written on 28/11/2017Past performance is not indicative of future performance