Euro High Yield Proves Resilient Against Pandemic Backdrop
High yield issuers are typically more dependent on growth, so a reflationary scenario makes the asset class relatively attractive. And while default risk remains a big fear, government support schemes and favourable financing conditions should help. Finally, as investors search for yield in 2021, high yield compares favourably to government bonds and investment grade credit.
The Backdrop for Euro High Yield
Markets have been volatile so far in 2021. Equities initially rallied to fresh highs before getting vertigo and retracing those gains. The creep of shutdowns, as a result of rising COVID-19 infections, has ensured weak economic growth to start the year; it is not quite the springboard that the market had anticipated. In addition, market volatility – largely a result of the GameStop shenanigans – has potentially caused some market participants to reduce their risk exposure.
Intermittent challenges to the orthodoxy that 2021 will be the year of the rebound are likely to continue to emerge, but the greater force is acting to support the economy. Growth should remain well underpinned by low central bank rates and ongoing asset purchases. Add to that substantial fiscal packages that have yet to feed through into demand. Furthermore, vaccine roll-outs should allow some reopening of the economy, which in turn would unleash pent-up consumer demand. While growth forecasts made in November 2020 may now appear optimistic, the most likely scenario remains a meaningful economic rebound in 2021.
In this context, we continue to favour European high yield bonds for three reasons:
High yield issuers are typically more dependent on growth, so this reflationary scenario makes the asset class relatively attractive. Of note during the January risk ‘wobbles,’ Euro high yield actually held up remarkably well. There was only one day during this period that the option-adjusted spread on the Bloomberg Barclays Liquidity Screened Euro High Yield Index moved wider than it had been at the end of 2020, despite sharp falls in equity markets. This hints at an underlying appetite to buy the asset class on any price weakness. This strategy could have served investors well in H2 2020, when spikes wider in spreads on the back of economic concerns typically proved short-lived.
Default risk remains the big fear for high yield investors. A slow start to 2021 presumably raises these risks but there are several reasons why this is not a normal credit cycle. The extension of government support schemes to help corporates through lockdown, in conjunction with favourable financing conditions, has bolstered corporate survival. It is notable that the pace of ratings downgrades has slowed significantly, with Moody’s downgrading 15 European non-investment-grade issuers in January 2021 against an average of over 90 per month in Q2 2020.1 Gross issuance is also likely to be lower than in 2020, creating a more favourable supply-demand dynamic.
Investors are likely to reach for yielding assets in 2021. Government bond yields are negative in the euro area and offer little in the way of potential capital gains. Yields on investment grade credit are also low, with spreads close to their tightest levels over the past two years. High yield offers not only yield but also low duration risk relative to government bonds. The Bloomberg Barclays Liquidity Screened Euro High Yield Index yields around 2.5% for a duration of 3.25 years against the Bloomberg Barclays Euro-Aggregate: Treasury Index with a yield of -15bp but a duration of over 8.8 years.2