European high yield bonds: Long Live the „Hunt for Yield“!

The share of euro negative yielding bonds keeps surging. This is the case mainly with government bonds where currently already 37% of the total outstanding euro government debt is offering negative yields. (€2’321 out of €6’305bn). Germany is on top with 62% of its outstanding debt offering negative yields. Finland and Netherlands with both 54% are not far away so Austria and France with respectively 43% and 45%. Outside of the Euro Zone for example Switzerland has 82% of it's outsdanding debt in negative yield territory.

The spill-over effect has already started in 2015 with Agency/Supranational and specially covered bonds. Now with Draghi’s decision to cut ECB's main interest rate from 0.05% to 0%, the bank deposit rate, from -0.3% to -0.4% and expand the quantitative easing programme from €60bn to €80bn a month including as well European investment-grade corporate bond market worth about €800bn, it will force investors to search for positive yields elsewhere or in other asset classes. We believe the European high yield bond market is a valid opportunity.

 Earlier this week in Stockholm, Senior Fund Manager Thomas Korhammer presented his arguments for this asset class in front of 50 investors.

European Default Outlook: Decoupling from US

• Euro high yield spreads overcompensate for default risks. They are very attractively priced in. Spreads levels compensates for default rate >8% whereas current rate are at 3,3%. Moody’s 12 month’s forecast are stable with 3,4%, where we even see a reduction of default rate in Europe going forward.
• Europe lags the US in credit cycle. The credit-clock in the US is currently on shareholders friendly measures whereas in Europe there is a more friendly bondholders environment. There are less M&A activities, there have been even recent dividend cuts and in general there is more management discipline from European companies.
• ECB supports economic and credit-cycle and Europe’s gradual economic recovery and low inflation outlook creates a sweet spot for credit investors benefitting from European companies staying focused on deleveraging and liquidity needs.

What else favours the European high yield market

• Europe benefits from a lower energy exposure of 7% compared to the US market with 12%. US yield pick-up is less attractive considering spread impact of energy sector.
  

• Duration and yields are higher the US yield market, but the average rating is lower, hence for a lower quality we consider the yield pick-up of approx. 70 bps compared to European high yields not really appealing on a risk/adjusted basis
• The European high yield market is nore to be considered as a diversified corporate market that offers enough attractive opportunities. The current market cap is roughly €400 bn of which 20% are sub-financials which came into this universe after 2008. Beside European companies, the universe includes as well roughly 20% companies from US or from emerging markets issuing bonds in Euro. 

Window of Opportunity

• Taking data from the 1st of March, yields widened by 215 bp in the last 12 Months going from 400 bp to 615. Valuations are attractive. Spreads in the European high yield market have overshot due to the spill-over of the US market, we can say he suffered in sympathy. High break-even spreads compensate for a widening of roughly 150 bp and implied defaults significantly exceed expected defaults. Such levels are normally only seen in recessions. But we are not expecting a recession in Europe nor in the US.
• Therefore there is a spread tightening potential which already started after ECB’s latest actions. Our scenario for the next 12 months foresee now a change in risk premium of -150 bp which leads to an expected market return of roughly 7% going ahead additionaly to the 2% already seen in the last week.
• Market liquidity stays nevertheless a topic as banks have offloaded high yield bonds of their own books and some spike in market volatility could create some bid-ask spread widening.

Avoiding losers is very important

The main value you will find in a high yield portfolio is the capacity of the team to avoid losers like recently Novo Banco which overnight lost 80% points. Not having the bond in the portfolio has brought 80 bps performance one shot relative to the portfolio's benchmark. Therefore a thorough selection plays a central role. Outperformance shall not be done at any cost.

Raiffeisen Capital Management* is a pioneer in managing European high yield bonds. The fund Raiffeisen-European-HighYield was launched at the beginning of the Euro high yield market in 1999 and shows an impressive risk adjusted track record of 17 years, tested already over two default-cycles and various bull and bear markets.

Our fund management team is on board from the beginning. The fund is characterized by a prudent investment approach. We prefer to give our investors a rather consistent performance on the long run avoiding some traps on the short term.

* Raiffeisen Capital Management stands for Raiffeisen Kapitalanlage-Gesellschaft m.b.H.