• Fixed Income
  • Credit

Global high yield in a sub-zero world

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

100 dollars frozen melt

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

  1. Laura Benitez and Tasos Vossos, ‘Sub-Zero Yields Start Taking Hold in Europe’s Junk-Bond Market’, Bloomberg, 9 July 2019
  2. Adam Haigh, ‘The World Now Has $13 Trillion of Debt With Below-Zero Yields’, Bloomberg. 21 June 2019
  3. Rachel Koning Beals, ‘Worst of high-yield bond defaults is yet to come – blame energy’, MarketWatch, 12 July 2016
  4. Global Fixed Income Bulletin, Morgan Stanley, July 2019

Author

Related views

Important information

THIS IS A MARKETING COMMUNICATION

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. Some data shown are hypothetical or projected and may not come to pass as stated due to changes in market conditions and are not guarantees of future outcomes. This material is not a recommendation to sell or purchase any investment.

The information contained herein is for general guidance only. It is the responsibility of any person or persons in possession of this information to inform themselves of, and to observe, all applicable laws and regulations of any relevant jurisdiction. The information contained herein does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it would be unlawful to make such offer or solicitation.

In Europe, this document is issued by Aviva Investors Luxembourg S.A. Registered Office: 2 rue du Fort Bourbon, 1st Floor, 1249 Luxembourg. Supervised by Commission de Surveillance du Secteur Financier. An Aviva company. In the UK, this document is by Aviva Investors Global Services Limited. Registered in England No. 1151805. Registered Office: 80 Fenchurch Street, London, EC3M 4AE. Authorised and regulated by the Financial Conduct Authority. Firm Reference No. 119178. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material. AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 138 Market Street, #05-01 CapitaGreen, Singapore 048946.

In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business address: Level 27, 101 Collins Street, Melbourne, VIC 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission as a commodity trading manager, exempt market dealer, portfolio manager and investment fund manager. AIC is also registered as an exempt market dealer and portfolio manager in each province of Canada and may also be registered as an investment fund manager in certain other applicable provinces.

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.