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Copyright Stephane Couturier

euro high yield credit as source of income

October 2019

High yield: where the income continues to flow

High yield debt is one of the few markets offering positive real income.

Times are getting tougher for bond investors. The curse of negative yields is spreading from sovereign bonds to investment grade credit. At the last count, USD15 trillion of sovereign and corporate debt globally was affected (see Fig.1).

fig. 1 negative yield dilemma

Global negative-yielding bonds, market cap in USD bn

Global negative yielding debt chart

Source: Refinitiv. Data from 31.01.2014 to 25.09.2019, taken from Bloomberg Barclays Global Aggregate Index

And all the while, corporate debt piles are rising. There are other complications, too.

Corporate bonds are generally becoming harder to buy and sell. That’s because banks, who as market intermediaries used to warehouse billions of dollars of bonds until they could find buyers, are no longer willing or able to take such risks with their balance sheets. 

This increases the potential for market volatility. And so does the growth of passive exchange-traded bond funds (ETFs). In the first half of the year, they accounted for 65 per cent of inflows into European high yield debt, according to JP Morgan data. These vehicles tend to buy only the most liquid bonds issued by the most heavily-indebted companies. 

In a market slump, such bonds’ liquidity could prove more of a curse than a blessing. Because they’re easier to offload when times are tough, they could suffer the heaviest losses. Indeed, we are already seeing them drop off first during any sell off.

At first sight, all this seems to be very negative for high yield debt. But that’s not quite the case. Non-investment grade bonds' fundamentals suggest they can weather an economic downturn. 

Their resilience in part reflects the fact that most of the return in high yield is derived from the coupon. Over an economic cycle – from growth to recession – 110 per cent of total return in high yield credit comes from income, countering what is, on average, a small capital loss. That means investment returns are not reliant on strong economic growth, but on the companies’ ability to pay their interest costs. 

A stable or even marginally shrinking economy should be enough to ensure these repayments are made. For example, between mid-2011 and mid-2016 – a period when euro zone economic growth was consistently below 2 per cent and which includes the bloc’s most recession – returns on European high yield averaged 7.8 per cent a year compared to 5.1 per cent for equities.

Another advantage is that the composition of the European high yield market is less cyclical than that of its US equivalent. The biggest sectors in the US, accounting for more than 15 per cent of the market, is energy. In Europe, meanwhile, telecoms lead with a 12 per cent share.

Improved credentials

One of the main risks in the high yield market is defaults, with both Standard & Poor's and Moody’s ratings agencies raising their expectations for 2020. But the situation is not as gloomy as may at first appear.

For a start, while default rates do indeed seem to be rising, they are still at historically very low levels and are expected to remain so. Secondly, today’s European high yield universe is more creditworthy than it has been in the past, with the average rating at BB- and just 5 per cent of debt rated CCC, the lowest rung. 

Furthermore, valuations are supported by limited supply: the European high yield market has actually shrunk in recent years.

As we enter the later part of this economic cycle, the high yield market continues to offer attractive opportunities and an increasingly precious source of income when managed conservatively (see Fig. 2).

fig. 2  precious income
European credit by rating, yield to worst, %
European corporate debt yields by credit rating chart

Based on the Bloomberg Barclays Euro Aggregate Corporate indices. Source: Bloomberg. Data from 29.06.2018 to 28.06.2019.

pictet am's approach to european high yield debt

Risk control

Risk control is vital. Capital preservation and liquidity retention are central to our approach. We therefore focus on diversification, specifically choosing not to buy more than 5 per cent of an existing issue, avoiding bond issues which are too small to have any meaningful liquidity, as well as capping industry allocation. Whether we look at individual investments or at the whole portfolio, our aim is to balance the degree of risk against the potential returns, using hedging where necessary.

Expertise

Our analysts specialise by sector and look at both investment grade and high yield corporates. That gives means they get a fuller picture of each sector and identify any migration opportunities early, such as Vodafone’s perpetual debt, which was downgraded to high yield in August.

Income opportunity 

To maximise the income opportunity, we use bottom-up analysis to scour the market for price anomalies. Today, the debt of cyclical and non-cyclical companies is similarly priced, yet companies whose profits are strongly linked to the business cycle will be more volatile in case of any economic slowdown than those whose goods and services are always in demand. We are  thus overweight non-cyclicals, such as telecoms and cable. Conversely, over the past year, we have remained underweight in both Italian and British credit in the belief that valuations do not reflect the respective political risks of those countries.