There’s been a lot of market turmoil recently. How has European high yield dealt with the volatility? With the interest rate rise by the US Federal Reserve still fresh in investors‘ minds and the added issue of slowing global growth, financial markets are more volatile. Most major equity indices posted negative returns at the beginning of the year. However, European high yield indices held up relatively well The Eurozone is no exception to the volatility but growth is still good enough for the bulk of high yield companies to continue to be able to service their debt obligations, and at a level that encourages conservative behaviour from management teams. European high yield also has minimal exposure to emerging markets, oil, energy and commodity sectors - meaning that lower commodity prices are beneficial to profit margins in the region. Furthermore, minimal maturities and a cash-rich investor base, lends technical support in a market where new issue supply has disappointed.
In such uncertain conditions, preparation is key and investors should ensure their portfolios are properly diversified. European high yield cannot escape the short-term global volatility but the high coupon asset class is weathering the storm better than most, making it a strong diversifier for fixed income portfolios.
Interestingly, worries about duration have faded a little. That was a big discussion in the first half of 2015, particularly in Europe where we saw a big back-up in government bond yields. Stubbornly low inflation, not helped by continuously falling commodity prices, is also part of the equation. If Quantitative Easing (QE) is ultimately successful in driving inflation higher then you want to avoid being too exposed to government bond risk.
It’s easy to group high yield in one basket, but today, more than ever, we have seen correlations between the two diverge. Currently, European high yield is lower yielding than its US counterpart, but with that also comes lower risk. Specific tailwinds that don’t necessarily apply to the US market, such as currency depreciation, have been helpful for several of the companies that we invest in, particularly those with external revenue streams. Also in Europe, there exists a very accommodative central bank, which again, is dissimilar to the US market.
The yield difference between the two markets is significant for several reasons. The US has fewer banks but have a lot more oil and gas exposure (roughly 15-20%), particularly on the exploration and production side. Additionally, the average duration of US high yield bonds is about a year longer than in Europe, making US high yield more sensitive to Government bond movements. Finally, Europe and the US are at very different points in the monetary policy cycle. The US has finished QE and is now tightening monetary policy whereas the European Central Bank have taken rates into negative territory and have now extended their bond buying programme. The relative tightening of monetary conditions, along with increased pressure in the energy sector, should cause default rates to tick up in the US before Europe.