Why crossover is ideal for returns in this low-yield era

Low yields, tight spreads. It will be a struggle to generate healthy credit returns in 2020. Where to invest, without chasing yield in high risk or very long duration? A balanced mix of short-dated crossover and Nordic credits can provide you with solid returns. Just over a year ago, spreads had widened and we saw an attractive entry point for High Yield. Then spreads tightened dramatically. So, while our HY recommendation turned out well for 2019 and HY can still perform in 2020, we don’t find spreads to be outright cheap.    

Pays to stay invested in HY but ECB supports crossover

The European Central Bank (ECB) will be keeping government yields negative for a long time to come. And its corporate bond-buying programme continues. This provides strong support for demand in short-dated, positive yielding credits.

Should you worry about HY? No. The fundamentals remain sound. Most issuers continue to report healthy results. Only a rare few have deteriorated. We do believe that non-systematic risk has risen, so we favour the most stable issuers. There is quite a lot of supply in HY. Fortunately, new issuance is mostly done for refinancing and the new issuance leverage remains low.

But should you sell HY? Again, no. Don’t sell just because of tight spreads. There needs to be a catalyst for spreads to go wider. Otherwise, hold on. What could be such a catalyst? The ECB’s strategic review of its inflation goal and tools is something to watch closely but we don’t expect any significant news on that front in the foreseeable future.

We believe it is still possible for B-rated bonds to perform. Spreads can remain tight for years, generating respectable carry returns. Meanwhile, BB-rated bonds stay in high demand from IG investors who are desperate for yield. Thus, for HY, it’s business as usual, so carry on.

ECB poses a sizeable risk for yield chasers

Some investors are taking on substantial risk when reaching for yield. Is the pickup in yield enough to compensate for the longer duration, higher credit risk or weaker secondary market liquidity? We don’t think so. Especially with the ECB reviewing its monetary policy strategy.

The potential for an ECB bombshell poses a great risk to those who chase yield in longer, riskier and illiquid bonds. A change in the ECB’s wording could cause spreads to widen dramatically, just as they did in the latter half of 2018. Short-dated and Nordic issues would serve you much better in such a reversal. An ECB bombshell is certainly possible although not very likely. Within the ECB, there is significant opposition against the corporate bond-buying programme.  However, it is important to be mindful of the large impact that any comment regarding this could have on longer, riskier credit spreads.

Short crossover & Nordics provide best risk-reward

Short-dated crossover and Nordic bonds continue to offer value and relative safety. Liquidity is not a major concern with Nordic bonds, despite their smaller issue sizes. The issues may be smaller, but the companies are often large and well-known, thus increasing the involvement of big local investors and traders. By focusing on these areas and not over-reaching to chase yield, you can benefit from:

  • low duration risk,
  • low country risk,
  • low credit risk,
  • low liquidity risk.

How do we generate returns from the short end when yields are low? Our strategy is to combine the highest yielding of short IG issues and the highest quality of short HY issues, along with the relative value from Nordic issues. While the Nordic bonds performed well in 2019, their spreads are not tight. Short-dated IG & HY still benefit from the roll-down effect, with the ability to generate a nice return as the bonds move down the issuer’s credit curve.

Evli is a pioneer in both the European crossover and the Nordic credit markets. We consider both to be our home turf. Our proven track record makes us well-known and trusted. The Evli Corporate Bond Fund dates back to 1999 when the European credit market was still in its infancy and the fund’s crossover strategy was exceptional. We have also been involved in Nordic credits for almost 20 years and used this experience when we launched our Nordic credit fund in 2016.

Our approach to combine European IG, HY and Nordic issues in distinct funds is still quite unique in a pan-European context. This approach allows our investors to participate in diversified, balanced and unconstrained portfolios that perform.

 

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 that was launched the same year 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 January 30th, 2020. 

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