Altered Backdrop Favours Euro High Yield
The prospect of an economic soft landing coupled with elevated inflation pressures is likely to support credit exposures. For investors looking to add a little more risk, euro high yield ETFs could present an opportunity.
As the chances of a recession have receded, investors seem more willing to take on additional risk. The backdrop for the global economy has improved with the re-opening of China and lower energy prices. These improvements are driving markets to the conclusion that a soft landing, rather than a more extreme recession, is likely. This appears to be backed up by European data amid a bounce in PMIs. The IMF now forecasts growth of 0.7% for the euro area in 20231.
The prospect of an economic soft landing coupled with elevated inflation pressures is a less-than-ideal backdrop for government bonds and, as a consequence, government yields have drifted back higher, reversing much of the early 2023 rally. That said, the backdrop is more constructive for credit exposures. We looked at investment grade exposures in the Q1 Bond Compass, but this stronger growth dynamic hints that it may be time for investors to assume a little additional credit risk.
Increasing Focus on Non-Investment-Grade Exposures
Flows into EUR high yield ETFs have started to pick up, with close to $400 million of net buying so far in 20232. The obvious appeal is yield: the Bloomberg Liquidity Screened Euro HY Index offers a yield to worst in excess of 6.6%. While this yield is down from recent highs of close to 8.5% from a historical perspective, it remains elevated. Yields are at even more extreme levels when looked at from the perspective of a risk-reward trade-off.
Figure 1 shows the yield to worst on the Bloomberg Liquidity Screened Euro HY Index divided by its option-adjusted duration. The combination of the rise in yields coupled with shorter durations (both due to the sell-off in bonds and because there was limited primary issuance in 2022, meaning the index maturity has shortened) has resulted in the yield per year of duration rising above two. Yields of more than 2% per year of duration have been rare during the past decade and, until recently, only touched that level during the height of the COVID panic.
There is also the added bonus that more of the return now comes through coupon payments, with the coupon return rising to 3.88% in 2022 from 3.38% in 20213. In effect, a relatively range-bound market would still deliver holders of high yield bonds comfortably positive returns.
Figure 1: Risk-Reward Trade-Off is Strong with Yield to Worst/Duration Ratio near Decade Highs
From Absolutes to Relatives
The absolute yield may have an appeal but that does not mean that there is potential for price gains. Indeed, a glance at the spread to underlying government bonds shows the credit spread has already narrowed considerably from the late summer wides. The option-adjusted spread (OAS) of the Bloomberg Liquidity Screened Euro HY Index is now in line with its five-year average, making it easy to argue that a soft landing for the euro area is already priced by the high yield market. However, this average is skewed higher by the COVID crisis and the volatility in spreads generated by the uncertainty around both COVID and the recent aggressive central bank actions.
Figure 2 shows the OAS of the Bloomberg Liquidity Screened Euro HY Index plotted against the Citigroup Economic Surprise Index. The index indicates that an improvement in the data, or positive economic surprises, do typically lead to tighter spreads during periods of market stability. However, it’s also clear that the spread can move in advance of the economic data, with the spread blow-out in 2020 on COVID occurring before the data deteriorated. Likewise, the 2022 spread wides look inconsistent with the still-reasonable levels of the index.
Put another way, the market rushed to price in a far more aggressive slowdown in activity than has occurred. This is still reflected in the current level of spreads, which look slightly wide to the level of sentiment and have room to move tighter if activity remains buoyant and market risk appetite stabilises.
Figure 2: Citigroup Economic Surprise Index vs. Euro High Yield Spreads
More backward-looking metrics are also holding up reasonably well. The Moody’s upgrades/downgrades ratio is at 0.6 for western European, non-investment-grade issuers but is at 1.75 for S&P actions. So it’s a bit of a mixed picture but both numbers are off the lows recorded in 2020 when COVID drove a rush of downgrades.
High yield prices could also find some support from limited issuance in this space. Issuance of European high yield totalled EUR 44.5 billion in 2022, just more than a third of that seen in 2021, according to Fitch Ratings. While demand does often draw out more supply, Fitch expects similarly low levels of issuance for 2023.