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Euro High Yield Had a Good Summer – Now What?
European high yield has had a strong run with the risk-on summer months allowing further gains. There are now some darker clouds on the horizon as a COVID-19 resurgence again threatens the economy.
Year-to-date returns for high yield remain negative but the initial bounce-back from the March sell-off was sharp and was followed by a second wave higher into June. The summer months were a little bit slower but returns over the past three months for the Bloomberg Barclays Liquidity Screened Euro High Yield Bond Index are still around 3%. The three key drivers have been:
- The economic rebound, with indicators suggesting a rapid recovery in most parts of the economy. For example, much of the survey data is largely back to levels that signal a more stable economy.
- A risk-on summer, as equity markets pushed higher. This fed through into optimism that downgrade and delinquency risk for high yield bonds had diminished.
- The hunt for yield. With European government bond yields largely in negative territory and investment grade (IG) spreads having compressed to their tightest levels since February, fixed income investors needed to look for alternative sources of return. High yield offers both yield and the opportunity for gains as spreads to IG compress.
The resurgence of COVID-19 and talks of new regional lockdowns raise questions over the degree to which the economic numbers can continue to improve. These hurdles are likely to act as a headwind to further high yield performance. However, with yields at over 3.5%1 , capital appreciation is less of a concern for holders of high yield funds.
That said, as long as the appetite for risk stabilises, high yield bonds should be able to continue to perform. As Figure 1 shows, the Bloomberg Barclays Euro High Yield Index has a high correlation to the S&P 500, which places it firmly in the risk asset category. Since March, the index’s reaction to some of the bigger swings in equities has been limited. In this respect, there may be some interest from market participants nervous about the recent instability in stocks to trim equity exposure and favour high yield.
Figure 1: High Yield is a Risk Asset but Has Been More Stable than Equities
Drivers – Returns from the Unloved Sectors
The Bloomberg Barclays Euro High Yield Index is up another 0.5% this month (as of 18 September), largely driven by a rebound in sectors that still lag the performance of the overall index. The three best performing sectors have been consumer cyclicals (+1.07%), industrials (+0.93%) and financials (+0.88%), which are the three sectors that remain down 3% or more year to date. Together these three sectors account for close to half of the index weight, meaning their gains have had a meaningful impact on the overall index.
This ‘catch-up’ play is also evident if index returns are split by ratings buckets. Investment grade credit was the first to rally as the ECB stepped up its credit purchases. This initially forced investors looking for yield into the higher rated segment of the non-investment grade paper universe and then gradually down through the lower-rated paper. In this case, the greatest returns for September have been in CAA2 and CAA3-rated bonds with 5.4% and 9.6% returns, respectively.
As long as there is no deterioration in market risk appetite, this convergence of spreads is likely to remain a key factor driving the performance of high yield funds. While lower-rated bonds have to price in a greater risks of default, the yield to maturity on the B3 and below rated tranches is in excess of 6% versus close to 2% for the highest non-investment grade, BA1, paper. With the spread between the Bloomberg Barclays Pan-Euro HY BB Rating only and CCC Rating only indices still close to 50bp wide to its 2014 to 2019 average, there remains room for further spread compression.
Darker clouds
While the summer months were kind to high yield investors, the resurgence of COVID-19 is not a positive backdrop. However, there are several reasons why we believe that material spread widening is not on the cards at this juncture.
- In contrast to the approach at the start of the pandemic, governments are trying to avoid economy-wide lockdowns. This should limit the impact on businesses.
- Many of the government measures put in place to aid corporate survival are being extended. Also, record levels of high yield issuance suggests corporates have pre-funded their financing needs and should be in better shape than in Q1 2020.
- The pace of ratings downgrades has fallen away quite sharply in Q3 2020, with S&P downgrades at 26% of their Q2 2020 level and Moody’s at 29%2 . Taken at face value, this suggests agencies have fewer concerns over financial soundness. It also means that the high yield market should have fewer ‘Fallen Angels’ to absorb.
Overall, concerns over COVID-19 are not seen receding in the near-term, which will create a more volatile backdrop for high yield bonds. However, a more robust corporate sector and the general resilience that high yield has shown to previous bouts of equity volatility could limit downside price risks. Indeed, with investors still searching for fixed income returns, any pairing back of risk appetite, as we witnessed in June 2020, could be viewed as an opportunity to add assets that deliver a consistently strong flow of coupon payments.
How to play this theme:
Investors looking to access European high yield exposure can do so through a SPDR ETF. To learn more about the ETF, and to view full performance history, please follow the link below:
SPDR® Bloomberg Barclays Euro High Yield Bond UCITS ETF (Dist)
Flows
European-Domiciled ETP Segment Flows (Top/Bottom 5, $mn)
European-Domiciled ETP Asset Category Flows ($mn)
Sources: Bloomberg Finance L.P., for the period 9-17 September 2020. Flows are as of date indicated and should not be relied upon as current thereafter.
* This information should not be considered a recommendation to invest in a particular sector, or security therein, shown above.
1Source: Bloomberg Finance, yield to worst as of 18 September 2020.
2As of 22 September 2020.
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Exp. Date: 30/09/2021