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EUR vs USA speculative grade market: a comparison from different angles

The essential

European HY lower exposure to the energy sector and its higher average rating quality with respect to the US asset class crucially contributed to European speculative grade bonds outperformance vs their American counterparties in recent quarters.

In this piece, however, we further investigate the differences in composition and underlying trends between the two asset classes, with particular attention to the bottom up risks they are exposed to.

 

Publication

In previous publications we have already discussed the macro differences in the composition of the HY corporate bond universe denominated in dollars and in euros: as we have already noted, in particular, the European HY universe’s lower exposure to the energy sector and its higher average rating quality compared to the US asset class have made a crucial contribution to European speculative grade bond outperformance vs. their American counterparts in recent quarters. Put simply, the collapse of oil prices and the increase in risk aversion impacted the USD denominated asset class more significantly than the EUR denominated one. In this box, however, we further investigate the differences in composition and underlying trends between the two asset classes, with particular attention to the bottom up risks to which they are exposed.

We provide a more in-depth analysis in the comparison below

1) Latest and expected trends in default rates:

  • The most recent data published by Moody’s clearly show an upward progression in the US after a prolonged period of stability in the area of 2%: the US HY default rate, in fact, rose to 2.3% in August, to 2.7% in September and finally to 2.8% in October. Moody’s estimated a further rise to 3.3% in December 2015. On the contrary, the same rate remained more stable in Europe and close to 2%, a level forecasted by Moody’s also for the last month of 2015. If we then focus on the main investible benchmarks, the divergence between the two sides of the Atlantic increases: the actual default rate which affected the bond universe, and which is priced in to the most widely used bond market indexes, is currently at 2.7% in the US, and thus in line with rating agencies data, but the figure is much lower for European companies (less than 1%). Our forecasts confirm a widening gap in the two trends during 2016: our top-down regressions point to a likely stabilisation of the European HY default rate at close to its current level of 2% by the end of 2016, while in the US the rate is expected to increase to a level between 4.5% and 5% from its current 2.8%.
  • From a sector and bottom-up perspective, the drivers of growing credit events in recent months were companies vulnerable to falls in energy and commodity prices, and in particular the lowest rated energy companies. The recent increase in the Default Rate (DR) to 2.8% is in fact almost exclusively attributable to the CCC category, of which the DR in twelve months has approximately doubled from 5% a year ago. All this while the same 12-month rate for BB-rated companies remained close to zero and the DR of B-rated companies was less than 1%. The third element that seems to differentiate the trend of companies’ failures is the relative size of the companies themselves: in the US, in particular, CCC-rated small caps suffered from an increase in DR from 5% to 13% last year, while the companies with the same rating but with larger size have undergone a smaller increase from 4%/5% to the current level of 8%.

2) Distress ratios: among the drivers of future company failures

  • As already highlighted in previous publications, the percentage of issues at or above a 1,000 bp spread is a good indicator of the future DR trend: the usual link shows a time lag of about a year between distress ratios and the subsequent DR. This relationship points to a further increase in bankruptcies in the coming months in both the energy sector, as well as the materials and retail sectors in the US. These three sectors currently look particularly “stressed” as their distress ratios range between 30% and 50%, while the rest of the US HY sector is showing a lower distress ratio level, between 10% and 25%. The recent trend, however, shows that in addition to retail, other sectors, such as media and automotive for example, are experiencing a rapid increase of this percentage. In Europe, the rate is still low (less than half of the US one) and consistent with a DR that is expected to remain around 2%.

3) EUR vs US HY: two different “beasts”

  • The table herein shows the main differences in ratings of the two universes of speculative grade bonds in question: the table shows weights in terms of outstanding debt and in terms of the number of companies. The quality gap, in particular, increases if one considers the number of companies (on which the subsequent DR measures are primarily calculated) and not the value of the underlying debt. The share of BB-rated debt is about two-thirds of the European market and a more modest 48% of the American one. However, if percentages are calculated on the number of issuers, these weights respectively fall to 43% and 23%, with the proportion between Europe and US consequently rising from 1.3 to 2 times. The other element that shows the higher risk implicit in the universe of US companies is the weight of CCC-rated companies (30% of the total number and 13% of the debt, both of which are double the European weights).
2016-01-08-tableau
  • Another important consideration is that the percentage of debt rated BB1, or the highest notch for a speculative grade bond, is double in Europe with respect to the US: 35% of European HY debt has a rating in fact only one notch away from IG, compared with only 15% in the US. Therefore, the quality gap is even wider. The European benchmark’s higher concentration in a lower number of companies increases this aspect of higher quality: according to our calculations, in fact, the top 25 issuers of the EUR denominated benchmark (by outstanding debt) account for about 40% of the total debt of European HY. Among these 25 main players in the European index, 15 are BB1-rated and another seven issuers are BB2/ BB3-rated: only three of the biggest 25 issuers are B-rated. The “size factor” (large cap/small cap), combined with the rating factor, therefore increases the defensive nature of the European HY universe, contributing to reduce its volatility. Most of these issuers with greater weights are in fact large-cap, with global business or financial "national champions" belonging to peripheral countries, which have fallen from investment grade into the speculative grade area in many cases because of the effects of the sovereign crisis on ratings of their respective sovereign entities.
  • The last aspect to consider is related to idiosyncratic risk: this risk in the US has increased significantly in the last two years with respect to European speculative grade. Spread distribution and spread performances during 2015 show a significant gap between the two sides of the Atlantic: performance dispersion has increased sharply in the US and remained much lower in Europe. Almost 250 US issuers suffered from a rise of more than 500 bp OAS in 2015, quite a “fat tail” in spread performance distribution as most of the issuers were somewhere between tightening and a 50 bp widening.

Quality gap increases if the number of companies and not the value of the debt is considered

 

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Cross Asset of January 2016 in English

Cross Asset de Janvier 2016 en Français

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BERTONCINI Sergio , Head of Rates & FX Research
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EUR vs USA speculative grade market: a comparison from different angles
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