Aberdeen’s high yield team gives a brief overview of the high yield market and outlines the potential benefits of investing in the asset class.
What is your view on the market in 2014?
We have a positive outlook for European high yield. Issuance has been in excess of €80 billion in 2013 and we expect over €100 billion in new issuance this year. New issues continue to be generally used by companies for refinancing purposes to reduce the cost of capital and lower the maturity profile of outstanding bonds. Both of which should help defaults to remain within the 2%-3% range versus the long-term historical average of 4%-5%.
Consensus total returns for the asset class are around 3% to 5%. Delving deeper, income yields are forecast to be approximately 7%. Investors could however experience some capital loss due to bonds being priced above their initial call price.
Lower levels of market liquidity as a result of the U.S. Federal Reserve’s (Fed) tapering actions and banks taking less risk on market-making positions may however cause European high yield returns to be more volatile in 2014.
Compared to U.S. high yield, what advantages do you see in the European high yield market?
European high yield has a number of favorable attributes over its U.S. counterparts. Firstly, the average credit rating within the European high yield market is BB compared to B in the U.S. – in part this is due to the number of ex-investment grade ‘fallen angels’ and downgrades that have occurred in European credit over the past few years. Secondly, European high yield has a comparatively lower average duration than the U.S. high yield market making it less susceptible to changing interest rates. Finally, Europe offers a higher spread per rating bucket. This is mainly due to the fact benchmark European sovereign bonds trade at much lower levels than their U.S. counterparts making the extra spread available within Europe more attractive than the U.S.
Moving beyond fundamental differences, the U.S. is showing more promising signs of growth than Europe at present with monetary policy normalization actions due to be initiated in January by the Fed. U.S. government bonds have risen as a result causing the spread available on U.S. high yield bonds to compress. Meanwhile, in Europe, lower growth means that government bonds are likely to stay lowerfor a longer period. In addition, company-level earnings are generally improving. Opportunities are therefore arguably more attractive in European high yield in the current environment.
Market consensus sees Europe will be out of recession in 2014. How will this benefit European high yield?
Europe is indeed moving out of recession however growth is still weak at around 1% with southern European countries showing the greatest promise. Nevertheless, improving economic growth in the region should help to improve confidence and encourage greater spending and investment. Companies will in turn benefit fromhigher sales and earnings growth, including those within high yield.
Will periphery countries continue to be a drag on investors’ appetite for European high yield?
Despite demand remaining weak, we are fairly positive on the long-term prospects of the periphery. Progress continues to be made at a sovereign level with focus shifting from short-term market access issues to the implementation of long-term structural reforms, political stability and debt sustainability. Improving conditions at a sovereign level have reduced the risk of peripheral countries exiting the Euro area and abetted any further sovereign level credit rating downgrades in the short term.
Investor optimism towards future growth potential within the periphery is reflected in the narrowing spread between peripheral and core European high yield bonds. A cautious approach is however still advisable - domestic demand continues to be weak and peripheral based companies that rely on domestic earnings will likelycontinue to underperform in the short to medium term.
Why should investors include European high yield as part of their portfolio?
European high yield can potentially benefit a wider portfolio by providing:
Attractive income potential – in the current low yield environment European high yield bonds can still provide a more attractive risk return profile than the widerbond spectrum.
Return potential in a low growth environment – while low global growth is a concern, high yield companies do not need robust growth to perform well. If anything, stagnant growth can help to promote cautious corporate behavior, which can support the value of high yield bond.
Downside protection – sub-investment grade bonds have a comparatively higher coupon component and shorter maturity profile than other fixed income instruments. This helps to lower the bonds ‘duration’ or the sensitivity of the bonds price to a change in interest rates, providing an element of downside protection. The outcome of the bond is still binary, that is its coupons and principal are paid or the bond defaults, but it is less likely to be effected by a change in interest rates than higher quality bond issues.
Diversification benefits – high yield bonds have a low historical correlation to government and investment grade bonds.