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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.
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:
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.
Marketing Communication. For Professional Client Use Only.
For Investors in Austria: The offering of SPDR ETFs by the Company has been notified to the Financial Markets Authority (FMA) in accordance with section 139 of the Austrian Investment Funds Act. Prospective investors may obtain the current sales Prospectus, the articles of incorporation, the KIID as well as the latest annual and semi-annual report free of charge from State Street Global Advisors GmbH, Brienner Strasse 59, D-80333 Munich. T: +49 (0)89-55878-400. F+49 (0)89-55878-440.
Finland: The offering of funds by the Companies has been notified to the Financial Supervision Authority in accordance with Section 127 of the Act on Common Funds (29.1.1999/48) and by virtue of confirmation from the Financial Supervision Authority the Companies may publicly distribute their Shares in Finland. Certain information and documents that the Companies must publish in Ireland pursuant to applicable Irish law are translated into Finnish and are available for Finnish investors by contacting State Street Custodial Services (Ireland) Limited, 78 Sir John Rogerson’s Quay, Dublin 2, Ireland.
France: This document does not constitute an offer or request to purchase shares in the Companies. Any subscription for shares shall be ade in accordance with the terms and conditions specified in the complete Prospectuses, the KIID, the addenda as well as the Companies’ Supplements. These documents are available from the Company centralising correspondent: State Street Banque S.A., 23-25 rue Delariviere- Lefoullon, 92064 Paris La Defense Cedex or on the French part of the site spdrs.com. The Companies re undertakings for collective investment in transferable securities (UCITS) governed by Irish law and accredited by the Central Bank of Ireland as a UCITS n accordance with European Regulations. European Directive no. 2014/91/ EU dated 23 July 2014 on UCITS, as amended, established common rules pursuant to the cross-border marketing of UCITS with which they duly comply. This common base does not exclude differentiated implementation. This is why a European UCITS can be sold in France even though its activity does not comply with rules identical to those governing the approval of this type of product in France. The offering of these compartments has been notified to the Autorité des Marchés Financiers (AMF) in accordance with article L214- 2-2 of the French Monetary and Financial Code.
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Spain: State Street Global Advisors SPDR ETFs Europe I and II plc have been authorised for public distribution in Spain and are registered with the Spanish Securities Market Commission (Comisión Nacional del Mercado de Valores) under no.1244 and no.1242. Before investing, investors may obtain a copy of the Prospectus and Key Investor Information Documents, the Marketing Memoranda, the fund rules or instruments of incorporation as well as the annual and semi-annual reports of State Street Global Advisors SPDR ETFs Europe I and II plc from Cecabank, S.A. Alcalá 27, 28014 Madrid (Spain) who is the Spanish Representative, Paying Agent and distributor in Spain or at spdrs.com. The authorised Spanish distributor of State Street Global Advisors SPDR ETFs is available on the website of the Securities Market Commission (Comisión Nacional del Mercado de Valores).
Switzerland: The collective investment schemes referred to herein are collective investment schemes under Irish law. Prospective investors may obtain the current sales prospectus, the articles of incorporation, the KIID as well as the latest annual and semi-annual reports free of charge from the Swiss Representative and Paying Agent, State Street Bank International GmbH, Munich, Zurich Branch, Beethovenstr. 19, 8027 Zurich, as well as from the main distributor in Switzerland, State Street Global Advisors AG, Beethovenstrasse 19, 8027 Zurich. Before investing please read the prospectus and the KIID, copies of which can be obtained from the Swiss representative, or at ssga.com/etfs.
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