What did we see last year?
2017 was a very accommodative year for European high yield credit. From a macro standpoint, the positive global growth story and synchronised economic expansion was very supportive for the asset class, with political headlines having little to no impact. The market continued to benefit from positive technical factors, as global demand for yield combined with a shrinking universe (arising from significant refinancing) to provide support for asset prices. Furthermore, high yield companies exhibited strong fundamentals with default rates below their long term averages.
All these factors combined to squeeze spreads tighter and tighter, with the yield-to-worst of the ICE BofA Merrill Lynch European Currency High Yield Index bottoming out at 2.27% in November.
This represented historically low levels of yield, and a point at which investors began to question whether they were still being compensated for taking the additional credit risk in high yield. As a result we saw some de-risking their portfolios, leading to some outflows from the asset class. Subsequent to these stretched valuations, in November we saw some idiosyncratic credit events which seemed to remind markets of the risks inherent in high yield, combining with a pickup in lower-rated issuance to push spreads wider.
Source: ICE BofA Merrill Lynch as at 28 February 2018
What has happened since then?
Since the start of the year, expectations of more aggressive tightening of monetary policy from the Fed have pushed government bond yields higher and credit spreads wider. This has resulted in a more attractive valuation picture for European high yield, with the ICE BofA Merrill Lynch European Currency High Yield Index now yielding around 3.2%. Approximately 75% of this yield move has been driven by credit, with spreads widening c70bps over this period.
This represents a significant pickup over European investment grade companies which are still yielding only 0.9% (ICE BofA Merrill Lynch Euro Corporate Index), while the extremely high currency hedging costs are an issue for European investors considering US high yield. This improved valuation picture remains against a backdrop of robust fundamentals, with the benign default cycle expected to persist over the medium-term.
We have also seen a shift in the yield curve, with the spread move more extreme at the short end. Yield-to-call bonds that were only fetching around 1% are now available with 2-3% yields, and as such the short duration universe represents a much more attractive opportunity set.
Source: Moodys as at 28 February 2018
What do we expect going forwards?
Looking ahead, the Federal Reserve is expected to raise interest rates another two or three times in 2018. By contrast, market participants believe, after terminating their asset purchase program by the end of this year, the ECB is unlikely to follow suit by raising interest rates until later in 2019. The end of the asset purchase program is fully anticipated by the market, although there is uncertainty around its precise timing. As such we anticipate the impact of the end to asset purchases being limited, and would note that we expect it to be less acute further down the credit spectrum and thus for high yield assets.
Back in October of last year, prices were being driven by the technical picture and yields were arguably squeezed too low. We believe this factor has unwound somewhat for high yield credit and markets are now once again being driven by fundamentals. With default rates forecasted to remain low, investors are now being adequately compensated for taking the credit risk in high yield.
Against a backdrop of rising interest rates and with credit assets underpinned by strong fundamentals, we believe a short duration high yield strategy could prove an effective option for investors. Such an approach can help to manage the impact of rising interest rates while capturing the attractive carry on offer from the asset class now that valuations are more appealing than they have recently been, particularly for short duration bonds.
We believe that our ability to identify yield premium via our rigorous credit research process while controlling volatility through careful portfolio construction helps us to generate strong risk-adjusted returns for investors, and are optimistic in our ability to do so in 2018 and beyond.