Endgame for the high yield rally?

We called the bottom in high yield and a strong rally followed. Is it time to lighten up, or stay invested?  

Early this year, we advised investors to increase their high yield exposure. This was in spite of the gloomy sentiment, a dead market for new issues, and a brutal end of 2018 for risk assets.

The advice certainly paid off. From January to May, the European High Yield index returned over 6.5%.

The sentiment was ripe for a reversal and valuations were again attractive for long-term investors. In our opinion, the November-December panic in the market was not due to any weakness in high yield fundamentals.

As we pointed out in January, the window of opportunity tends to be narrow after an end-of-year spread widening so robust. And we knew the rebound could be just as powerful.   

Negative sovereign yields are keeping demand high for short-duration credits. But what added fuel to the rally were the longer-duration assets, with recent interest rate moves helping longer-dated credits outperform.

HY fairly priced, rally losing steam…

The rally this year has been even stronger than expected. We don’t expect it to continue at such a torrid pace but there is still room for spreads to tighten.

The risks that we saw in January do still exist, but sentiment has improved. And those risks are less HY issuer-specific and more macro-specific, including the US & the Fed, China, and political risks in Europe.

In contrast, high yield fundamentals are still robust. High yield new issuance has come back to life and, importantly, the new issue leverage has stayed low. And the “Use of Proceeds” for new bond issuance is now less credit negative than at any time in recent history.

Most companies have reported healthy results, while only a few have disappointed. European default rates are very low, and we expect them to stay there. Companies continue to benefit from the low rate environment and the reasonable debt levels.

… but where else to go? It pays to stay invested!

Yes, the rally has been strong, and one might look for a reason to lighten up now. There will certainly be hiccups, as in Q4/18, at some point in the future as well. But where else can you achieve positive returns? The “search for yield” era continues, as many asset classes have very low or negative yields, particularly in fixed-income.

At a current level of 406bp, the European high yield spread is very close to the level we saw in parts of 2016-2017. And if you held HY back then, it has paid to stay invested. In the three years since, the HY market has boasted cumulative returns of over 15%. 

Similarly, when the spread for single-B rated bonds has been at current levels, around 575bp, this has also led to very attractive returns over the following three years. Historically, the spread has been tighter than it is now about 45% of the time (B rated, 1999-2019).

Good returns in high yield do not require strong economic growth, but rather the avoidance of a recession. Thankfully, the European macroeconomic outlook remains one of slow, but positive growth.

No more low-hanging fruit, credit selection is key

It’s one thing to time the market right and benefit from a rising tide that lifts all ships. It is quite another to expertly select the proper credits. Now is the time when carefully picking the right credits takes on extra importance, as the pace of the rally eases and credits that run into trouble can be punished severely.

Evli is a pan-European credit specialist that has proven its ability to select the right credits, boasting an excellent track record across several fixed-income asset classes. Within high yield, we find the best potential is to be found in the more stable, senior High Yield bonds, as well as in Nordic credits.

In this low rate environment, the Evli European High Yield fund offers an attractive yield-to-maturity of 5.0%, a moderate duration of 3.0, and a sound average credit rating of BB-.

 

Text: Mikael Lundström, MSc (Econ), Chief Investment Officer at Evli. Mikael has invested in the European High Yield market since it’s birth in 1999 and has been the portfolio manager of Evli Corporate Bond fund and Evli European High Yield fund since launch. He holds a Morningstar Analyst Rating for his funds.

Mikael Lundstrom 

Interested in further reading? See our section on Nordic Bonds and download the white paper The Nordic Corporate Bond Market. 

 

This article has been published on May 9th, 2019. 

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