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The investment case for short term eur high yield bonds

March 2019

High yield – but not as you know it

Europe's evolving high yield bond market offers income-oriented investors new possibilities – without the need to take on a high level of risk.

European investors face a conundrum. On the one hand, they need to protect their portfolios in the face of lacklustre economic growth, continued sabre-rattling on trade and the rise of populism.  

On the other, the available pool of defensive income-generating assets is shrinking, particularly within Europe's sovereign and high-grade bond markets. Despite the end of European Central Bank’s quantitative easing programme, yields on government debt and other high quality fixed income securities are near zero or even negative when inflation is taken into account. 

The question, then, is how can investors secure enough income without taking on excessive risk? European short-term high yield debt may not be the obvious answer, but we think in the current climate it's a viable option. And for several reasons.

Strong fundamentals

For one thing, the quality of European high yield bond market has improved significantly in the past decade. It is now a liquid and diverse asset class, featuring companies operating across a wide range of industries. Today, some 71 per cent of the universe is made up of BB-rated bonds – just one notch below investment grade; this is up from 54 per cent in December 2008.

comfort level
European high yield – net leverage as proportion of EBITDA
European high yield – net leverage

Source: Morgan Stanley Research. Data covering period 01.03.2003-30.09.2018.

Non-investment grade European companies have in the main been very cautious about borrowing since the 2008 crisis. At just 3.2 times earnings before interest, tax, depreciation and amortisation (EBITDA), their net leverage is below the 15-year average (see chart). Other indicators of indebtedness – including the free cash flow to debt ratio and interest coverage – also look healthy relative to history. 

Moreover, default rates among European high yield bond issuers are running at just 1.5 per cent compared to 13 per cent during great financial crisis, and are expected to remain low over the coming year.1

Of course, if there is a recession, companies will find it harder to refinance their obligations and default rates will creep higher from the current low levels. But the fallout should be limited given that many European high yield issuers have already refinanced most of their near-term debt, shifting the maturity wall – the point when the majority of debt will need to be paid back or refinanced – out to 2022.

Furthermore, recent central bank action has reduced the probability of a recession occurring in the first place. The US Federal Reserve has signalled a pause in interest rate hikes. The ECB, meanwhile, has pledged to keep rates on hold until 2020, and has unveiled a new Targeted Longer-Term Refinancing Operations (LTRO) stimulus programme to support banks' lending to businesses across the euro zone.

Sweet spot

The combination of low interest rates and slow but steady economic growth is generally positive for high yield bond markets.  

And by focusing on shorter maturity debt in particular, investors have the potential to secure higher levels of income without the volatility normally associated with the asset class.

Indeed, investing in shorter duration non-investment grade bonds is a strategy that has proved its mettle – both during the market turbulence at the end of last year and over the longer term.

Since its inception in 2012,  the Pictet-EUR Short Term High Yield strategy’s maximum peak to trough decline  or "drawdown"  has been much smaller than that for the broader high yield and investment grade universes, as well as for the equities market (see chart). It has also achieved a  lower annualised volatility of returns over that period than any of the other investments in the comparison.

caution pays off

Maximum drawdown by strategy/asset class, % of absolute value 

Maximum drawdown by strategy/asset class

Source: Pictet Asset Management. Performance for Pictet-EUR Short Term High Yield gross of fees excl. swings, ICE BofAML Euro Investment Grade Constrained Index, JP Morgan EMU Government Bond IG index, ICE BofAML Euro High Yield Constrained Index and MSCI Equity Index, Data covering period 31.01.2012 to 31.01.2019.

The resilience of short-term high yield debt is helped by the diversity of the market, which enables us to express a wide range of investment views.

Brexit is a case in point. Even though the UK is mired in uncertainty over its departure from the European Union, we continue to believe it is still a powerful economy with many strong businesses. To reflect both these considerations, we have tilted our portfolio towards non-cyclical businesses, confining our UK holdings to bonds that will mature over the next two years.

The recent calming of tensions between Italy's populist government and the EU is another development that investors can benefit from via the short term high yield bond market. We are looking to modestly increase our holdings in short term Italian corporate bonds as we believe their valuations underestimate the potential for a brightening in Italy's prospects. Here, we would also consider relatively longer maturities – three or four years rather than one.

Focusing on the final legal maturity of the bonds rather than on their duration – a measure more traditionally targeted by portfolio managers – helps to further reduce portfolio volatility. It is an important distinction because most high yield bonds are callable, with duration measured to the first or subsequent call date. That carries extension risk: if a company’s position deteriorates, it will not take up the call option, leaving the bond holder with more risk. Looking at the final maturity rather than duration can thus help to achieve more stable returns.

To sum up, high yield need not always mean high risk. With support from increasingly dovish major central banks, stable corporate fundamentals and a manageable near-term maturity wall, we believe short-term high yield debt offers a rare opportunity to generate an attractive income stream with limited volatility.

limiting risk: pictet eur short-term high yield strategy in action 

Strong performance track record

Strategy returned -0.80 per cent in 2018, compared to -3.6 per cent for the broader European high yield market.

Modified duration of 1.7 years

Longest maturity positions – of four to six years – make up just 10 per cent of the portfolio and are spread over 20 to 30 issuers to further limit risk.

Focus on strong credit quality within universe

Debt rated CCC or below accounts for less than 3 per cent of the portfolio – versus maximum allowed 10 per cent.