Marked preference for European HY

Euro investment grade corporate bonds posted negative returns in September. The lack of new policy measures from the ECB and anxiety regarding the future actions of the Federal Reserve generated weakness in the market. The rally that took place following the decision by the Fed to keep rates unchanged proved to be short lived as concerns over Deutsche bank (and the fine levied by the SEC) weighed on sentiment. Junior issues, contingent capital and hybrid corporate bonds posted the lowest returns of the subordinated spectrum, European high yield underperformed, with spread ending the month 30 basis points wider (compared to 10 bps in European investment grade). Supply was heavy in September and inflows decelerated, moving towards Emerging markets as political risk in Europe is likely to be elevated in Q4.

Marked preference for European HY

The European high yield segment appears to be fairly stable. We do not observe any drastic increase in leverage, and the EBITDA margins are holding up quite well (compared to IG margins). In terms of valuations, yields are relatively higher when compared to fundamentals. Spread-adjusted to leverage is well remunerator compared to US HY, where companies have a lower credit quality. Moreover, US companies are more sensitive to a change in Fed policy while in Europe, the ECB QE remains in place. Finally, technicals in the market also appear to be supportive. Inflows are decelerating, though not drastically.

US HY only a carry story

Yield in the segment remains attractive. However, when adjusted to losses induced by percentage of CCC rated bonds, the US HY asset class does not appear to be juicy. Even if the rhythm of downgrades is slowing, US default rates reached 5% at the end of September and will certainly reach 5.5-6% by the end of the year, before stabilizing later in 2017. US high yield corporate balance sheets appear to be quite leveraged with an average debt to capital ratio of 72% and an operating leverage of 7.6x. After positing more than 15% returns, the oil rebound has now been integrated and we do not expect massive spread tightening.  

Selective on CoCos, though regulatory framework is supportive

The regulatory framework remains a key driver of spreads on bank contingent convertibles. The central bank (ECB) is reducing the capital burden of banks by replacing a portion of its binding requirements (in terms of coupon payment) with non-binding guidance. It will also specify that banks will not have automatic restrictions in Additional Tier 1 (AT1) coupon payments when they incur a loss. This would give flexibility to the banks and is in general positive for the AT1 market.

The asset class continues to offer an average yield that is similar to the HY market. Technicals are also sound as there is a strong appetite from investors, which are primarily asset managers, insurance companies and pension funds.

However, we remain selective as the asset class could witness volatility as a result of specific events such as any announcement of new regulations, litigation risks on several banks (including Deutsche, RBS, Barclays and Credit Suisse) and Q3 results. These events are likely to shake the segment and lead to some periods of spread volatility. In this context, we look to adopt a bottom-up approach to the asset class and be extremely selective while picking the appropriate issuer structure.