Last year may have ended poorly for the bond market that witnessed a red wave during the November-December sell-offs. However, 2019 has begun on a calmer note and valuations look attractive for long-term investors.
The last two months of 2018 were exceptionally volatile for the fixed-income market. The spreads widened significantly during the November-December sell-offs and the bond market witnessed high volatility. Both high-yield (HY) and investment-grade (IG) notes experienced losses and it was one of the worst quarters for HY bonds since 2011. This made investors nervous as the markets were in the red.
However, markets have now calmed down in January 2019.
There were a series of factors that led up to the November-December sell-offs.
Weak macro and global growth worries, fear of market reactions when European Central Bank (ECB) ends its bond-buy program, fear of a trade war between China and the US and the possibility of a hard Brexit all added to market nervousness. Weakening of growth in China was the most relevant of these market fears.
Additionally, 2018 was not a spectacular year neither for the average bond investor nor for the market makers and this also contributed to the sell-off. In December, when market-makers observed that they had slim returns from the year and the market started getting softer, they stopped taking new positions and further risking their books. This created an impression in the market that buyers were disappearing and resulted in a selling frenzy to avoid missing the last of the buyers. It was a reaction that was not based on fundamental weaknesses.
But macro-political and economic sentiments have improved since then. The potential of a China growth slowdown is still there, but the probability of a hard Brexit is lower and the US and China seem to have come to an agreement. Although some of these fears have not been ruled out completely, the market is starting to look more positive.
Safe to swim
What this means for investors is that the yields are currently at lucrative levels, especially in high-yield bonds with a market yield to maturity rate close to 5%. Last time the yields were this high in the HY category was in late 2015 and early 2016, and before that in 2012.
For single-B rated HY bonds in Europe, the spread has either stayed below or close to the median level for most of the time since 1999. However, during the end of 2018, there was a drastic rise in the spread, going upwards of this median level. Now, in January 2019, it has started coming down again. This means the markets are calming, yields are starting to decrease, and prices are moving upwards once again.
Another point to be noted from historical data is that when the spreads have widened so much, it has always been for a short time. That means the opportunity to invest is not only rare but the window to step in is also short. These are buying times and not selling times when spreads are clearly above the long-term median.
Ride the tide
So, what is in the price? Eurozone growth is expected to be 1.5% per annum in 2019. We believe that EUR HY will perform well as long as growth stays positive, leaving some room for even growth disappointments. Defaults, albeit a lagging indicator, are low. But more importantly, company leverage has stayed low. Growth in Europe has been slow but positive in the last 10 years and the HY market has been very strong. So good returns in HY segment is not dependent on spectacular growth, as long as a severe recession is avoided.
The present spread of single-Bs of 650 have always, on a three-year horizon, worked well for the investor. In fact, investing at these levels have usually given a three-year return well above 20%. Even on a one-year time frame, the outcome has mostly been clearly positive. However, some negative 12-month periods have also occurred.
Of course, nobody can predict the short-term market movements and we really don’t know what will happen next month. But, for any long-term investor, it’s time to start increasing their HY bond investments. With a three-year horizon, at these levels, there is a very high probability of earning very good returns.
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.
This article has been published on February 1st, 2019.