The macroeconomic environment continues to be supportive of high yield

Growth in the USA was disappointing in the first quarter of 2015 but set to rebound in the next quarters at a moderate 2.5% annualized pace. In contrast, the Eurozone surprized on the upside and eventually showed some signs of life. Growth would stay at low levels in the euro area, with no recessionary risks in the foreseeable future.  One key supportive factor to growth is the lower oil price. Despite the recent rebound, oil trades 45% lower in USD and 33% lower in EUR than at its peak. This low- to moderate-growth environment is supportive of high yield. Since 2010, growth in the USA averaged 2.2%, the default rate was only 1.3% and US high yield delivered annualized returns of 8.9%.

 

The ECB QE is also currently supportive of high yield. It is crowding investors out of the euro government bond market and supporting reallocation flows into higher yielding segments: from sovereign to investment grade and from investment grade to high yield in Europe but also in the US which is offering a pick-up of 1.5% vs. European high yield. So far, the ECB QE is not bearing fruit. Inflation expectations are not yet anchored. They are lower now than when the QE was announced. Thus, the ECB remains committed to QE and reallocation flows would continue to be supportive of high yield.

 

In addition, the GBP strength is in favour of GBP-based investors. The hedging of a EUR portfolio into GBP is currently generating a yield pick-up of around +0.8% and of nearly +0.3% for a USD portfolio.

 

Turning to risks, investors would face the risk of rising rates and/or volatile rates. The recent rate sell-off in Europe had consequences beyond Europe: both US Treasuries and Gilts followed suit. This market phase highlighted that the risk / reward in rate markets is not appealing: 1) it would take 15 years on average for German sovereign debt coupons to make-up the losses incurred during the recent sell-off 2) so-called “safe-haven” assets like US Treasuries or Gilt did not fulfil their role as risk diversifier. This is of high importance for high yield investors because high yield is not immune to the interest rate risk. In May and June 2013, which is the most recent and material rate increase episode in the US, interest rates detracted from US high yield returns -1.3% in May and -1.1% in June while at the same time 5-year US Treasury yield increased respectively +34 bps and +37 bps

 

Investors would also face a liquidity risk in the high yield cash bond market. The US high yield bond market which is the world’s largest is fragmented: 54% of US high yield issuers have 4 or less outstanding bonds (18% has only 1 bond), leading to fragmented and patchy liquidity conditions. The average daily trading volume per bond in the US high yield market is just 3.5 M$ (3-month volume). Liquidity concerns would be exacerbated in the EUR and GBP markets which are much smaller in size, respectively 4 times smaller and 15 times smaller than the USD market.

 

To circumvent the interest rate and the liquidity risks in high yield, which continues to look attractive: yields today are close to yields at the end of 2013 while macroeconomic conditions have improved, we prefer high yield CDS indices. US and European high yield CDS indices outperformed high cash bond markets since 2004 with lower volatility (8.7% vs. 10.5%) and much lower maximum drawdowns during the credit crisis). The outperformance of CDS indices amounted to +18.3% during the credit crisis.

 

First, CDS indices have no interest rate exposure. They would be immune to rising or volatile market conditions. Second, they are liquid in all market conditions with an average daily traded volume of 5.5 bn$ for the US high yield index and 4.3 bn$ on the European high yield index. Thus, the trading costs for high yield CDS indices are just a fraction of in the high yield cash bond market: 10 bps vs 150 bps in Europe. Third, valuation is attractive. CDS indices compensate for a 6% default rate when expectations stand at around 2.5% in the US and in Europe for the next two years. High yield CDS indices remain cheap. CDS indices offer a pure corporate high yield exposure with no exposure to EM high yield issuers or subordinated banking debt, Tier 2 or Tier 1, that are parts of the high yield bond markets. Finally, the exposure is well-diversified across 175 North American and European issuers. In conclusion, high yield CDS indices offer a yield of close to 6% with no interest rate risk and high liquidity when the rule of thumb in fixed income markets is higher yield, higher interest rate risk and less liquidity.

 

 

 

About Olivier Debat

Olivier Debat joined UBP in August 2010 as an Investment Specialist dedicated to fixed income. Previously, he spent two years at Allianz Global Investors in Paris working on Euro Fixed Income strategies, with a focus on investment-grade and high-yield credit products. Before joining Allianz, Olivier spent four years at Credit Agricole Investment Bank as an Account Manager in the Global Oil & Gas Division and then as an Associate on the Equity Capital Markets desk. Prior to this, he was an Equity Analyst at Credit Lyonnais for four years. Olivier is a graduate of the EM Lyon Business School and holds the CEFA diploma.

 

 

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