Marked preference for European HY

Although all asset classes posted negative total returns in November, the high-yield markets suffered less than investment grade. In spite of the sharp upward move in rates, global high yield posted a very small negative performance ($ was positive), thanks to the spread buffer. Indeed, Euro investment grade corporate bonds – led, to  a large extent, by the consumer, IT and real estate sectors –  continued to decline. Financials and the banking sector suffered to a lesser extent, though the riskier subordinated debt performance lagged.

Marked preference for European HY

The European high-yield segment appears to be the most attractive segment, posting a relatively low duration and much higher yields than the other credit markets. It is also demonstrating better credit quality than US high yield. We do not see a 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 more remunating compared to USD high yield segment, 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 has been extended, though at a lesser amplitude (60 bln. vs 80 previously). Finally, Technicals also appear to be supportive. Inflows are decelerating, though not drastically, and supply appears to be lower than in previous years. Finally, there doesn’t appear to be a high wall of maturity, as most redemptions are 3-4 years away.

Continue to favour European financial credit

On the investment grade front, European financials offer more interesting spreads than the non-financial sectors, which appear expensive when we look at the Spread-per-leverage ratio. Bank credit also appears to be resilient in the face of the increase in sovereign rates as well as the event risk that has been omnipresent in the current markets. Furthermore, in a rising yield environment, financials tend to be better performers (historically).  

Within the financial sector, we continue to prefer the CoCos, which appear to be attracting renewed interest. In terms of yield, these instruments are on a par with US high-yield credit levels. Furthermore, 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. The ECB has also published a report on the capital requirements of each bank. This would give flexibility to the bank and is, in general, positive for the AT1 market. 

Technicals are also sound, as there is a strong appetite from investors, who are primarily asset managers, insurance companies and pension funds. 

However, we remain cautious, as the asset class could witness volatility as a result of specific events such as the announcement of new regulations, and of the litigation risks on several banks. The “No” vote in the referendum in Italy has sparked fear over the re-capitalization issues in Monte Paschi bank. While this is a specific issue related to a single bank, the contagion effect could spill over to some of the subordinated debt in Eurozone banks. Additionally, events such as these are likely to shake the segment and lead to periods of spread volatility. In this context,  we look to adopt a bottom-up approach to the asset class and be extremely selective, while taking care to pick the appropriate issuer structure.