European High Yield is still an attractive yield play
European High Yield (HY) debt has performed quite well so far this year, with a total return of 4% for the asset class over the first six months of the year. Going forward, we believe European HY still represents an attractive asset class as it is well supported by the macroeconomic environment and the credit fundamentals, while also the technical picture is benign. In addition, the yield of 4.1% compares favourably to other fixed income asset classes, particularly European government bonds or investment grade credits.
We expect that the Brexit vote in the UK will not affect the economic outlook significantly. While growth estimates for the European economy may be revised downward somewhat, from a fundamental point of view, we see little impact on the global economy from the Brexit outcome. Obviously, the depreciation of the pound sterling (GBP) is likely to affect companies with GBP earnings and non-GBP costs. Besides, corporate and consumer confidence in the UK will likely be impacted negatively. However, in contrast with the perception of many market participants that live and work in London, we believe that Brexit is not likely to derail the positive momentum in global credit markets, as we think the UK is simply not important enough. We do not expect a material increase in credit losses as a result of Brexit.
From a macroeconomic point of view, we see the recent job numbers in the US illustrating the resilience of the US economy. On the flip-side, we do acknowledge that continued strength in macroeconomic data comes at the risk of increasing rate hike expectations. At the same time we think that an increase in rates should be seen as a sign of underlying economic strength and not as a threat to the high yield market.
From a valuation point of view we are still comfortable with high yield, both in Europe and in the US. Valuations are not extreme and both historically and versus other asset classes, like government bonds and investment grade credits, high yield spreads still compare favourably. So without signs of any substantial credit deterioration, a decent macroeconomic backdrop, and relatively fair valuation levels, we remain constructive on high yield as an asset class.
The ‘search for yield’ is clearly a dominant theme in fixed income markets. An additional supportive factor in the short term is the technical picture. Both in Europe and the US, the search for yield continues. With limited new issuance expected (due to blackout periods and summer holidays), high cash levels amongst investors, conservative market positioning (as reflected in the YTD underperformance of most active managers), zero inventory at investment banks and the offer-less market of the last days, we believe that the near-term technical picture is likely to be positive for HY credit.
In Europe, in addition, the ECB’s quantitative easing program is a supportive factor, both in terms of size and in terms of bonds eligible for the program. The inclusion of corporate debt has led to a very supportive market environment and to a further tightening of yield levels. The lack of yield on government debt, as well as the low yields on investment grade corporate debt, is forcing investors to go for lower credit quality to realize higher total return levels.
Wrapping it all up, we believe European HY will continue to be able to provide attractive returns. We believe that barring any unexpected external events, investors can expect the asset class to return approximately 4.5% over the next twelve months. In our view, this total return represents an attractive investment opportunity.
Sjors Haverkamp, head of European High Yield at NN Investment Partners