Global high yield: European bonds in pole position
Despite the risks of slowing global growth and more falls in oil prices, prospects for European high-yield debt are particularly encouraging, says Kevin Mathews.
It has been a tough time for high-yield bond investors over the last eighteen months as slowing economic growth and a sharp slide in oil prices spooked financial markets. Indeed, January saw the second worst start to a year since 20001. However, bonds have rallied strongly since the middle of February, as fears over the economy ebbed and as oil prices began to recover. By the end April, high-yield bonds had returned 6.71 per cent1 since the start of the year. But can the rally continue given the risks facing the global economy and mounting corporate indebtedness?
In the last 18 months, much of the movement in high-yield bond markets has been a consequence of energy businesses’ debt, especially bonds issued by US energy companies. Demand for oil has slowed with prices more than halving since mid 2014, in turn reducing energy companies’ profitability and increasing the risk of issuers defaulting.
Energy issuers face further falls in oil prices
The market has become more optimistic on the outlook for oil prices since February. In our view, it is now too optimistic. We doubt oil prices will hold above $50 a barrel for long given current production levels and US inventories. In any case, fracking companies will struggle to make a profit even at current oil prices.
Ultimately, some high-yield energy companies may be unable to meet their costs and could potentially go bust in the coming months. Furthermore, some better-quality, or investment-grade, energy issuers may be downgraded to high-yield status.
Despite recent concerns over global growth, a recession is unlikely in the short term. So, while we expect default rates to rise this year, primarily due to a surge in defaults by energy businesses, overall rates are unlikely to soar. Indeed, stripping out energy issuers, default rates for high-yield bonds globally should be close to their historical average with no clear trend in terms of which types of industries are likely to suffer most – which is a healthy sign. Indeed, default rates for non-energy companies may fall slightly in coming months.
The lion’s share of high-yield debt is issued in the US, with energy businesses accounting for four-fifths2 of high-yield issuers in the country. The European high-yield market is only around a third2 of the size of that in the US, though Europe’s share of the global market was only a seventh a decade ago. That is because as bank lending, especially to riskier companies, has slowed since the financial crisis of 2008, more companies have been forced to turn to debt markets.
High-yield bonds issued by financial companies comprise a larger portion of the European market. It has been far more common for banks to raise capital in Europe through debt issuance than in the US. And, this trend is likely to persist as banks in the region look to raise capital to meet tougher capital adequacy requirements.
Mind the gap
We expect the US Federal Reserve to hike interest rates once or twice more this year after doing so for the first time in almost a decade in December. Meanwhile, the European Central Bank (ECB) may take short rates deeper into negative territory. Against this widening gap between US and European interest rates, the former looks far closer to the peak of the ‘credit cycle’ than Europe.
Furthermore, the ECB is planning to start buying higher-quality euro-zone corporate bonds as part of its asset purchases. This added demand for investment-grade bonds should boost prices and lower yields, adding to the appeal of high-yield bonds in its wake.
The persistence of negative interest rates in the euro zone is likely to hit banks’ profitability. However we believe European banks’ balance sheets look reasonably healthy and high-yield bonds issued by these banks continue to offer value.
The average maturity for high-yield bonds is much shorter than for investment-grade bonds. In high yield there is far more opportunity to influence performance through portfolio positioning than by making calls on interest rates.
Pockets of value
In our view the best value found among high-yield bonds at present is among the better quality debt, or those with credit ratings of double B or lower BB. We remain cautious on bonds issued by energy companies, which are likely to underperform given the market’s optimistic expectations on oil prices, and our view on potential future energy price weakness.
We believe global high-yield bonds will return between three per cent and five per cent in 2016. While this is lower than in recent years, returns still look decent compared with those likely from better quality bonds and shares.
The outlook for the asset class looks most promising in Europe, especially given its lighter weighting to energy companies. Issuers in the financial and consumer discretionary sectors offer particular value, with companies in the latter group likely to profit from higher consumer spending spurred by increasing confidence and lower oil prices. While high-yield bonds in the continent yield roughly half of those in the US, the latter market looks like struggling until we see signs that commodity-related defaults are close to peaking. Furthermore, the outlook for monetary policy is relatively favourable in Europe.
That said, we expect high-yield bonds may struggle in the short term. There remain risks of bouts of volatility in financial markets in coming months, perhaps emanating from disappointing economic growth, a shock monetary policy shift or a surprise fall in commodity prices. So, while investing in high-yield bonds should be rewarding, it does contain more risk than higher quality asset classes.
- Despite having their second worst January since 2000, high-yield bonds returned 6.71 per cent1 in the first four months of 2016
- While default rates are likely to rise in 2016, as more energy businesses default, they are unlikely to soar
- Some investment-grade energy issuers may be downgraded to high-yield status in coming months
- We believe global high-yield bonds will return between three per cent and five per cent in 2016. While this is lower than in recent years, returns still look decent compared with those likely from better quality bonds and shares
- The outlook looks most promising in Europe, especially given its lighter weighting to energy companies. Issuers in the financial and consumer discretionary sectors offer particular value