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Sunita KaraGlobal Co-Head of High Yield @SunitaKara
In the strongest signal yet that central bank policies are upending the investment playbook, sub-zero conditions are extending to the high yield market for the first time. Sunita Kara, looks at the implications for investors.
3 minute read
Bond investors, especially in Europe and Japan, have long tolerated having to pay for the privilege of holding safer government bonds in the loose monetary environment. Even so, the cost of that privilege is scaling new heights, putting investors in a more precarious position if circumstances suddenly change.
In July, Bank of America Merrill Lynch estimated that around €3 billion of high yield bonds issued by 14 companies had entered negative-yielding territory,1 joining US$13 trillion of global bonds already trading below zero.2 And it’s not just sovereign debt; almost a quarter of the investment grade market is also negative yielding.
Yields may become even more negative if, as expected, major central banks cut interest rates or renew bond-buying programmes. While dovish monetary policies can help spur economic growth by lowering the cost of borrowing, they hurt debt investors looking for income who must climb higher up the risk ladder to obtain returns. A globally integrated high yield strategy may help to optimise risk-adjusted returns.
The vast majority of high yield bonds remain in positive territory, averaging close to six per cent, according to the Bloomberg Barclays Global High Yield xCMBS xEMG 2% Capped Index, as of 31 August 2019. While this is below the historical average of about eight percent, they are still an attractive source of income.
High yield investors are typically paid for three primary return components: risk-free rates, credit spreads, and the illiquidity premium. All three are under increasing pressure. First, risk-free rates are largely driven by central banks, and are at historically low and in many case sub-zero levels. Second, credit spreads remain fair but are tightening. This reflects macro trends, stable fundamentals and a shrinking illiquidity premium due to technical factors. There is simply more demand than supply for the asset class, with our estimate on the supply of high yield bonds to be as much as 15 per cent lower in 2019 compared to the previous year.
In the short term, high yield investors appear to be in a sweet spot for collecting income, at least if the economy remains stable. However, macro conditions could quickly deteriorate given the backdrop of trade wars and geopolitical tension. Meanwhile, the available cushion against an economic downturn is dwindling. Spreads are tightening 11 years into the credit cycle, rattling investor nerves. At this late stage, a more selective approach within a broader, more diversified set of global opportunities is needed.
The US dominates the global high yield market, and the outlook there is underpinned by relatively healthy macro indicators. GDP growth, for example, is slowing but remains at about two per cent, which should support companies in increasing revenues, preserving margins and paying down some of their debt. However, US high yield is dominated by energy companies, which could leave investors overexposed to oil prices. In 2016, plunging oil prices contributed to a six-year high in defaults.3
In contrast, European high yield is dominated by the financial sector. This comes with different risks, but generally financial issuers have more conservative capital structures and higher average ratings. However, the European high yield market faces a weaker macro backdrop. It is also less than a third of the size of the US market.
It could therefore be beneficial to combine both US and European high yield opportunities to exploit valuation opportunities, capture capital structure inefficiencies and diversify exposures to different business cycles, credit conditions and other trends. An integrated approach may also increase yields on a currency-hedged basis without increasing credit risk or default probability.
For example, sometimes bonds issued in different currencies by the same company can have a sizeable spread pickup – even those with relatively similar maturities, credit ratings and covenants. Take Netflix. The company’s euro-denominated bonds maturing in May 2029 provided 91 additional basis points of option-adjusted spreads compared to the equivalent denominated in US dollars, according to our analysis, as of 31 August 2019. The reasons for the valuation difference vary and may partly reflect a home bias among US investors for Netflix, which is based in California. As demand among US-based investors push up prices for high yield bonds issued in their home currency, euro investors looking at the asset class from a global vantage point may benefit.
On average, euro-denominated bonds traded at about 67 basis points wider than similar dollar-denominated bonds in at least 46 multi-currency issuers. However, in some cases, dollar-denominated bonds were trading at higher spreads than their euro-denominated equivalents, so it is important to carefully analyse the risk-return characteristics of specific issuers. The difference may be as little as 30 basis points or as much as 100 basis points. And in a world in which total spreads of US and European high yield bonds were around 375 basis points and 300 basis points in July,4 that should give investors some comfort.
References
- Laura Benitez and Tasos Vossos, ‘Sub-Zero Yields Start Taking Hold in Europe’s Junk-Bond Market’, Bloomberg, 9 July 2019
- Adam Haigh, ‘The World Now Has $13 Trillion of Debt With Below-Zero Yields’, Bloomberg. 21 June 2019
- Rachel Koning Beals, ‘Worst of high-yield bond defaults is yet to come – blame energy’, MarketWatch, 12 July 2016
- Global Fixed Income Bulletin, Morgan Stanley, July 2019
