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High Yield bonds, the major outperformers of European fixed-income markets

The essential

In the fi rst three quarters of 2013 HY bonds outperformed other major segments in Eur Fixed income market and their cumulated returns are now close to our expectations for the fullyear.

Yield carry has become a stronger contributor of recent and future performance, as spreads normalized. QE tapering expected to start not before Q1 2014 means that yield hunting forces are not over yet: our numbers show that the strongest role HY bonds may play as “yield supplier” is actually within the short to medium segments of the yield curve. Lower duration and default risks together with stronger technical factors are also behind our preference for short to medium HY bonds in the next months.

In previous cross assets we focused on the evolution of Eur High Yield (HY) market and on the comparison of the main features of Eur HY with US HY bond market, showing to what extent and how rapidly the Eur HY bond has become a real asset class thanks to a combination of supportive factors. In a recent cross asset we also underlined the rationale behind current and expected low default rates in Europe, despite the challenging macro environment and a still fragmented fi nancial system. In this focus we analyze drivers of recent performance and focus on factors which may lead future returns from the asset class.

How to read 2013 HY performances and what to expect from the next months and quarters?

Eur High Yield bonds outperformed both Eur Investment Grade bonds and Government bonds year to date. In the fi rst three quarters of 2013 speculative grade bonds delivered an excess return over government bonds in the 7% area, much higher than excess return delivered by IG bonds, the latter positive as well but just below 2%. So far, only IG periphery fi nancials were able to almost match HY performance, with their 6% cumulated excess return. As far as HY performances are concerned, 2013 looks very much like 2010. They both pointed to a normalization of performances, after two years of extremes: 2008 Lehman crisis followed by 2009 strong recovery triggered by US policy response and 2011 European sovereign crisis followed by 2012 strong recovery thanks to ECB action. Year to date cumulated performance is very close to our full year target we outlined at the beginning of this year in our central scenario, namely in the high single digit, between 7% and 9%. The so called carry component or the coupon contribution is playing a more relevant role this year, as spreads tend to tighten much less than in recovery years, though still by a decent full percentage point on average. Spread contribution is therefore less than 50% of overall performance so far, while it reached around 80% of 2012 performance. As opportunities for further spread tightening are more and more limited, giving current valuation and possible further normalization in bond yield levels, our message is that carry will continue to be even more the main source of returns in 2014.

Technical factors remain strong for Eur speculative grade bonds: from spread hunting to…spread hunting again

Early Summer Fed announcements on a possible, though perceived as only gradual QE exit strategy, led to a sudden and strong re-pricing in fi xed income markets which at the outset involved HY bonds, too. Many players saw in the Fed’s wording a sudden shift from previously persisting low yield regime and a consequent end to the search for yield and spread hunting forces. Actually, subsequent dovish messages sent by Fed members and in particular by Bernanke (for example on their growing uneasiness with too low inflation levels or on uncertainties about progress on fi scal issues) led investors to reconsider their positions and fl ows returned positive in HY dedicated funds. The first graph reported shows how steadily positive investment fl ows into European HY dedicated funds turned after initial reactions to Bernanke remarks on QE tapering. Unlike to emerging bonds, HY bonds tended to recover their previous appeal to investors almost immediately or in just a few weeks, though with more volatility in the US than in Europe.
September FOMC then surprised most of market participants as the Fed decided to delay QE tapering: suddenly, this decision motivated by many factors in the released statement and during the Q&A session following the FOMC looked to “offi cially” reopen the space for a persistant search for yield and spread hunting. In our view, speculative grade bonds proved to protect investors better than other fixed income segments from negative effects of rising yields as well as generatinghigher positive performances when yields stabilize or move in range trading. That’s why we continued to overweight the asset class even in a rising yield environment (see September cross asset on the link between spreads and bond yields), as HY bonds can counterbalance negative duration effects with a spread tighteningpotential. For the same reasons we continue now to support a positive view on the asset class, as the search for yield seems to be back at least for some time. QE tapering start; once expected in September looks now postponed for at least some months as also the recent signals from the labor market do not seem to pressure the Fed which, by the way, doesn’t look in a hurry to start the exit strategy.

A dynamic primary market, absorbed by strong demand. The HY primary market had a terrifi c growth this year. Year-to-date issues of private debt have reached €58 billion, versus €32 billion and € 30 billion in 2012 and 2011, respectively. New issuers are entering the market (disintermediation). The HY market is supported by signifi cant flows. Private debt in the HY category is increasingly emerging as an indispensable asset class.

This environment of abundant liquidity gives us an outlook of very auspicious default rates in 2014. In August, the Euro HY default rate had a 12-month rolling average of 3.4%, according to the latest statistics published by Moody’s. The majority of issuers that default are fi nancial. The prospect of the default rate improving (2.7% a year from now) is supported by a liquidity environment that is favourable for many issuers. We are at the centre of a virtuous circle: (1) strong demand for credit is helping issuers refi nance their debt easily, and (2) historically low borrowing rates are also sharply reducing borrowing costs. What is more, European businesses are staying cautious with their cash management in a context of weak growth.

What are the curve buckets of European fi xed income market where the search for yield looks more “irresistible”?

In previous issues, we already addressed the topic of yield concentration in both European and US fi xed income markets to give a quantitative sense of the technicals supporting the search for yield. We re-ran our calculations referred just to the Eur fixed income market, and interestingly, the picture has not changed dramatically
during the summer. Graph 2) shows that the upward move in bond yields and partial spread tightening recorded in months following Fed announcement reduced the contribution of high beta spread products to the overall yield available in the fixed income market but probably to a lower extent than one could expect. The graph shows that since June the contribution to overall yield represented by IG periphery (corporate + government) bonds and HY bonds has fallen by just a few percentage points below 50%, while debt weight has remained below 30%.

One particular feature of the European HY market is its very low average duration, around 3 yr, lower than IG average duration (more than 4 years) and much lower than Government bonds duration. As most of HY bonds are concentrated in short to medium curve buckets where, at the same time, government bond curves look more fl at we run some calculation on yield concentration by curve buckets. Interestingly, results show that periphery and HY bonds make for almost 70% of 1-3 yr segment, almost 60% of the 3-5 yr and and 57% of the following 5-7 yr segment. The contribution then falls to 45% in the long term 7-10 yr segment. If we exclude from the computation periphery governments and just focus on IG periphery and HY bonds we come to the following graph: HY bonds play a strong role in the 1-3 yr segment and especially in the 3-5 yr segment, but the more we move along through the curve the lower it appears the role of HY as “yield supplier”. In conclusion we would like to show that the search for yield benefi tting demand for HY bonds is much stronger within the short to medium segment and this represent another rationale for the preference for short-term HY bonds. Other rationales for this preference have to do with lower default risks over the next few years, lower duration risk in case of a normalization in bond yields and lower spaces for further spread tightening. Finally, at current spreads short-term HY bonds offer around 200 b.p. spread widening break even vs government, which means that in one year time YTM should move from today’s 4% area to the 6% area to start offsetting the carry component vs bunds.

> European high yield market trend

Over the past fi ve years, HY outstandings have increased 172%. This growth has given rise to profound changes in the composition, quality and risk profi le of HY corporate bonds. Today, the European HY market offers:

  • Greater diversifi cation of issuers. The fi rst fi ve issuers make up only 17% of the index compared to an average of 27% for the 2002-2012 period.
  • Exposure to the fi nancial sector. Prior to 2005, there were only non-fi nancial issuers on the HY market. Now, fi nancial “fallen angels” make up a remarkable proportion of the European HY market: Banca Monte dei Paschi, Italy’s third-largest bank, was downgraded to HY in December 2012. This segment also includes many subordinated debt securities (Tier 1 and lower Tier 2).
  • A higher average rating. The category of BB-rated securities has grown, due in large part to these “fallen angels.”
  • More pronounced exposure to Europe and GIIPS (Greece, Italy, Ireland, Portugal and Spain). Until 2005, the market was dominated by issuers from the US, the European core and the UK. Of the 115 issues that currently make up the HY fi nancial issue segment, 48 involve peripheral countries.
  • Lower exposure to cyclical sectors. In 2013, fewer than half of issuers belong to cyclicalsectors, compared with more than two-thirds in 2006.

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From spread hunting to…
spread hunting again

 

 

06-01
06-02

 

HY bonds play the strongest
role of “yield supplier” within
short to medium curve
buckets

 

06-03

 

06-04
06-05

 

 

Valentine AINOUZ, Strategy and Economic Research at Amundi
Sergio BERTONCINI, Strategy and Economic Research at Amundi Milan
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High Yield bonds, the major outperformers of European fixed-income markets
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