European high yield: Reliable source of income
Investors are facing an unprecedentedly challenging investment landscape. Income-generating securities are scarce as nearly €5trn of European fixed income assets are yielding below zero. So those requiring a decent yield will no doubt find themselves having to take more risk than they have been used to. Yet while the risk-yield trade-off is a complex decision, the unfolding dynamics in Europe’s high yield bond market suggest the asset class should be considered a reliable source of income.
For one thing, high yield investors can count on benign financial conditions remaining in place for quite some time. While the US Federal Reserve will probably raise interest rates again this year, the European Central Bank has pledged to expand its monetary stimulus if necessary. The ECB has started buying corporate bonds under its Corporate Sector Purchase Programme, which is expected to run at least until March 2017.
Although the programme is mostly geared towards investment grade credit, the benefit for the high yield part of the market should not be underestimated, not least because around 3.5% of the benchmark BofA Merrill Lynch EUR High Yield index is eligible for ECB purchases. Under the programme, the ECB is allowed to buy corporate debt based on the highest available rating provided by four eligible credit rating agencies, not the average rating.
What’s more, the central bank is not required to sell in case a bond is downgraded to high yield. In the UK, the Bank of England announced an easing package in August, including corporate bond buying for the first time – an encouraging event which should underpin the UK high yield market as well. All this is taking place at a time when Europe’s economic environment – characterised by moderate growth and falling unemployment – should provide a decent backdrop for the asset class.
It’s not just benign monetary policies should support high yield bonds. Other factors will reinforce high yield bonds’ ability to generate income.
Non-investment grade companies in Europe are in good financial shape. The interest coverage ratio – which shows how easily a company can pay interest on its debt – in the EMU area stands at 3.5, compared with the 20-year average of around 3. In addition, European high yield firms do not need to refinance heavily after a busy 2015, in contrast to the investment grade market which is experiencing heavy issuance activity. European corporations issued €25bn of high yield paper on a gross basis so far this year, half that of the same period in 2015 and the lowest amount since 2008.
These positive trends, coupled with easy monetary conditions, suggest default rates among high yield issuers should remain low. With the default rate implied by market prices at more than twice Moody’s central expectation of just 2.8%, European high yield investors are well compensated for default risk, and, indeed, better compensated than investors in the US high yield market.
Structural trends will also boost high yield credentials as a strategic asset class – primarily size, diversity and liquidity. The European high yield market has grown more than four-fold since end-2007 to €310bn as of end-June as an increasing number of companies in Europe make the switch from bank to bond financing. As the market has grown, its credit profile and liquidity has improved. Indeed, a key structural difference between the European and the US high yield bond markets is the quality of bond issuers. The proportion of issuers in the benchmark index rated triple-C or below stands at just 5% for Europe, compared with 13% in the US.
Furthermore, European high yield bonds also enjoy better liquidity than their US counterparts, which makes such securities cheaper to trade. Providing further evidence of the European market’s increased liquidity and heft is BofA Merrill Lynch’s decision to increase the minimum bond size for its high-yield bond indices to €250m from €100m for euro-denominated issues and to £100m from £50m for sterling-denominated issues.
There are some concerns about the euro zone financial sector. Italy’s financial sector, with €200bn of net bad debt, is a particular drag on the euro zone’s third largest economy and its credit growth. The country also faces a political risk ahead of the constitutional referendum in the autumn. Italian prime minister Matteo Renzi has said he will resign if voters do not approve the changes which he hopes will reform Italy’s political system. With polls showing many of the 50 million voters undecided, it is a political gamble for the leader. That said, I find it positive that Europe is tackling its banking sector problems. Stricter regulation should strengthen banks’ balance sheets and reduce leverage in the industry. While negative interest rates weigh on their profitability, I believe European banks should come out of the deleveraging process stronger and healthier, which could give us some buying opportunities in the sector.
Roman Gaiser is head of High Yield at Pictet Asset Management