Want Safer Yield? Cycle to Europe

For high-yield investors with large US credit exposures, these are uncertain times. The pricing of securities is becoming more volatile, spurred by interest-rate volatility, and companies are borrowing more, causing concern about their future creditworthiness. The solution, in our view, is to diversify—and we regard the European high-yield markets as attractive.

A telling way to compare high-yield markets is to look at their positions in the credit cycle. Theoretically, the cycle begins with companies deleveraging after a recession and generally behaving conservatively. As the cycle progresses and recession eases, the companies stop deleveraging. As the economy recovers, they become more confident and start to borrow again.

Credit investors typically monitor the cycle, buying and holding during the early stages as interest rates fall (and the outlook for bond prices is positive) and balance sheets are strengthened.  Once the cycle passes its mid-point and companies take on more debt, investors naturally look for more conservative opportunities, such as markets that are still in the early stages of the cycle.

This is where the US and Europe are now, relatively speaking, with the US much more advanced in the cycle. In terms of quarterly real GDP growth this year, Europe has improved but remains in negative territory as many countries still struggle with recession, persistently weak demand and fiscal austerity. Quarterly real GDP growth in the US has picked up again recently and is currently just short of 2.0%. So, on this macroeconomic measure, the US is clearly far more advanced than Europe.

We expect this disparity to continue for a while. For next year we forecast 3.2% growth for the US (on a fourth-quarter comparison basis) and just 1.1% for the euro area. There are bright spots on the horizon in Europe, however, with strong growth this year from key leading indicators, such as Purchasing Managers’ Indices and economic sentiment.

As far as the credit cycle is concerned, important indicators for high-yield investors are those detailing default rates and borrowing trends. As shown in the chart below, default rates among European high-yield issuers are trailing well behind those among US and emerging-market high-yield issuers. This suggests that credit risk—the single biggest risk for high-yield investors—is lower in Europe.

The second display, below, confirms this trend:  net leverage among European high-yield issuers is falling, but it is rising among US issuers.

To some extent, the growing leverage among US companies is linked to a much higher level of merger and acquisition activity than that experienced in Europe. As well as stretching company balance sheets, such activity can be disruptive for bond holders if companies in which they are invested are acquired by third parties.

Aggregate leverage among European high-yield issuers is also lower than it is for US issuers, so clearly, from a risk perspective, Europe is more attractive—and this is likely to remain the case for some time, with the region’s recovery lagging so far behind that of the US.

This is not all, however, because European high-yield bonds are more attractively priced, too, with the yield on single-B credits 96 basis points higher, on an option-adjusted spread basis, than those on the equivalent US securities.

Perhaps the biggest doubt at the back of investors’ minds when considering diversifying into Europe is the risk of another flare-up in the sovereign debt crisis among peripheral euro-area countries. We believe that the risk remains but is muted, and that supportive government policies—together with the cyclical improvement flagged by the leading indicators—will help to contain it.

To put this in perspective, it’s important to remember that the European high-yield market consists mainly of debt issued by companies from developed-country economies. The investor base is also less retail-oriented than in the US, which helps to explain why European high-yield bonds performed much better than US securities during recent global interest-rate volatility.

Taking into account all these factors—plus the ease with which the euro  can be hedged—we think now is a good time for US high-yield investors to consider diversifying into Europe.

 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

Gershon M. Distenfeld, CFA

Director—High Yield and Investment-Grade Credit
Gershon M. Distenfeld is Senior Vice President and Director of High Yield and Investment-Grade Credit at AB, responsible for overseeing the investment strategy and management of all investment-grade and high-yield corporate bond portfolios and associated portfolio-management teams. Strategies under his purview span the credit and risk spectrum, from short-duration investment-grade corporate bond portfolios to regional and global high-yield portfolios, encompassing a range of investment approaches, objectives and alpha targets, from income-oriented buy-and-hold strategies to active multi-sector total return strategies, and including both publicly traded securities and private placements in developed and emerging markets. Distenfeld also co-manages AB’s award-winning High Income Fund, recently named “Best Fund over 10 Years” by Lipper from 2012 to 2015, and the award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. He also designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. Distenfeld is the author of a number of published papers, including one on high-yield bonds being attractive substitutes for equities and another on the often-misunderstood differences between high-yield bonds and loans. His blog “High Yield Won’t Bubble Over” (January 2013) is one of AB’s all-time most-read blogs. Distenfeld joined AB in 1998 as a fixed-income business analyst, and served as a high-yield trader (1999–2002) and high-yield portfolio manager (2002–2006) before being named Director of High Yield in 2006. He began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. Distenfeld holds a BS in finance from the Sy Syms School of Business at Yeshiva University, and is a CFA charterholder. Location: New York.

Jørgen Kjærsgaard

Head—European Corporate Credit
Jørgen Kjærsgaard is Senior Vice President and Head of European Corporate Credit. He is responsible for all of AB’s European and UK corporate credit–related strategies, and heads the European and UK High Yield and Investment Grade Credit portfolio-management teams. Kjærsgaard is a member of the Credit, High Yield, European High Yield, Global High Income, Multi-Sector Credit, and UK and Euro Fixed Income portfolio-management teams. He is also a member of the internal Credit Research Review Committee, the primary investment policy and decision-making committee for all AB’s credit-related portfolios. Kjærsgaard has authored a number of published papers and blogs, including ones highlighting the importance of a diversified portfolio and issue selectivity in the European corporate credit markets. Prior to joining AB in 2007 as a portfolio manager for European Credit, he was executive director for Structured Credit Solutions at Rabobank (2005–2007) and a director for Nordic Structured Solutions at Royal Bank of Scotland (2004–2005). From 1994 to 2004, Kjærsgaard worked in both London and Copenhagen for Danske Bank, where he spearheaded the firm’s credit derivatives trading and managed-mortgage and corporate credit portfolios. He holds a BSc in business administration and an MBSc in finance from the Aarhus School of Business at Aarhus University. Location: London

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