Focus
Point
In-depth insights from NN Investment Partners
The outlook for European High Yield bonds shared by the Credit Boutique of NN Investment Partners.
European High Yield Bond Outlook
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As a result of the low yield environment, investors have been willing to take on additional credit exposure
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European high yield bonds offer an attractive compensation as default rate is expected to remain low
Outlook for European High Yield Bonds
Main points
Declining interest rates have fuelled strong returns for many fixed-income asset classes in the first quarter of 2015. A key driver was the European Central Bank (ECB)’s decision to implement in March a program to buy government bonds. These purchases drove bond prices up so high that yields on most government bonds of the Eurozone have not only reached new all-time lows but, in some cases, have driven their yields into negative territory. The economic environment of moderate growth, low inflation, high unemployment and the ECB’s pledge to pursue its quantitative easing (QE) program until at least September 2016 suggest that yields on government bonds will likely remain low, if not negative, for quite a while. This low interest environment has also produced record low corporate borrowing costs for the largest companies. As a result of the low coupons on debt issued by governments and the investment grade companies, investors face a significant dilemma. Either they must dramatically adjust downward the expected returns on their new investments in response to this new world of low yields or they must accept additional risks in order to maintain the previous yield levels on their fixed income portfolios. More and more, investors have done the latter, piling money into high yield (HY) bonds. The average annual return on European HY bonds (ex-subordinated financials) over the last ten years is close to 10.5%, largely outperforming all other segments of the credit market.
Graph 1: European High Yield Index
50 100 150 200 250 300 350 05 07 09 11 13 15
Source: Reuters Thomson Datastream, NN IP (2005-2015)
NN IP currently holds the view that European HY bonds still offer an attractive compensation for the credit risk (a higher risk of default or other adverse credit events relative to investment grade credits). Although the overall yield levels are low from a historical point of view, spread levels are still considered as fair. More gener-ally, NN IP currently prefers spread products, such as European HY bonds, over (German) sovereign bonds as credit spreads have room to tighten further even in case of upward pressure on rates.
Graph 2: EUR Fixed Income 2005-2015
60 80 100 120 140 160 180 200 220 240 05 07 09 11 13 15
EUR GVT BONDS EUR INVESTMENT GRADE EURO CONVERTIBLE EURO HIGH YIELD Eur Gvt Bonds Eur Investment Grade
Euro Convertible Euro High Yield
Source: Reuters Thomson Datastream, NN IP (2005-2015)
Definition of a HY bond
A HY bond is also known as a non-investment-grade bond, a speculative-grade bond or a junk bond. It is a bond issued by a company that is rated below investment grade. These bonds (rated BB to C at Standards & Poor’s and/or Ba to C at Moody’s) have a higher risk of default or other adverse credit events, but typically pay higher yields than higher-quality bonds in order to compensate for the higher risk and to make them attractive to investors.
While some government debts have ratings below investment grade (like Greece or Venezuela), many HY indices do not include them and focus on corporate debt. Many subordinated debts of financial institutions have fallen below investment grade as a result of the financial crisis. Some indices also keep them as a special asset class, out of the core HY universe.
Table 1: European HY market statistics
Europe Number of Issues 670 Marketsize 333 bn EUR Yield to Worst 4.4 Credit Quality BB-OAS 4.1
Modified Duration to Worst 3.6
Source: Bloomberg, HPS2 Index (benchmark NN (L) European High Yield) Data as of 30 April 2015
Speculative European non-financial issuers include well-known companies such as KPN, Lafarge, ArcelorMittal, Peugeot, Renault, ThyssenKrupp, Portugal Telecom or Suedzucker to name a few1.
1 For illustration purpose only. Company name, explanation and arguments are given
and do not represent any recommendation to buy, hold or sell the stock. The secu-rity may be/have been removed from portfolio at any time without any pre-notice.
European HY bonds have gained in importance in recent years. European HY market capitalization has reached 333 billion EUR. At the end of April 2015, the average yield-to-worst offered by European HY bonds was 4.4% for a modified duration to worst of 3.6 years.
Corporate bond yields are loosely correlated with those of sovereign bonds. Typically, the lower the rating, the lower the correlation. Returns on HY bonds show a low correlation with sovereign bonds. They have a higher correlation with higher-risk asset classes like equities and emerging market bonds than with government and investment grade bonds.
Table 2: High Yield bond correlation matrix
HY bonds correlation of monthly returns over previous 10 YMSCI Europe 0.71 S&P 500 0.50
MSCI EM 0.66
MSCI Asia ex Japan 0.63 Pan Europe bonds -0.13
EMD 0.74
Global bonds -0.21 Commodity 0.42 Hedge funds 0.52 Leverage loans 0.82
Source: JPMorgan Q2 2015 Guide to the markets Europe
More information on the HY market is available in annexes 1 and 2 on page 8.
Current yields and spreads in perspective
Current European HY bond yields trade near historical lows. Yield-to-maturity currently stands at 4.7% while yield-to-worst stands at 4.4%.
Changes in HY bond yields can be influenced by two major variables: changes in the yields offered by Treasuries and changes in the spreads issuers have to pay to compensate for the risk of default, liquidity and/or downgrade.
Investors chasing positive returns in European government bonds are fast running out of road. Only six weeks into the ECB’s €1 trillion-plus bond-buying program, more than half of the Eurozone government-debt market offered investors a negative yield. Given that yields fall as prices rise, this means European government bonds markets have never looked so expensive. The yield on 10-year German government bonds – the Eurozone benchmark – fell to 0.05% in April 2015 before rebounding to 0.6%. Five-year yields on German Bunds fell to minus 0.14% on 17 April with eleven European countries having negative yields on their 5-year debt. The fall in (German) sovereign bond yield was an important cause of the decline in HY bond yields in recent months.
Graph 3: European High Yield versus 10-Y Bund Yield
0 5 10 15 20 25 30 05 07 09 11 13 15
German Bund High yield
Source: Reuters Thomson Datastream, NN IP (2005-2015)
Yield spreads between European high yield bonds and 10-year Bunds rose dramatically in 2008-2009 from 230 basis points to 2500 basis points at the peak of the financial crisis. They now stand close to 410 basis points, up from 310 basis points one year ago and still above the pre-financial crisis levels. Spreads are largely influenced by the expected number of companies likely to default in the coming 12 months.
Current corporate default in perspective
A default can be generally defined as a failure of a debtor to make timely payments of principal and interest. Rating agencies characterize default as encompassing any missed or delayed disbursement of interest and/or principal, bankruptcy, receiver-ship and distressed exchange.
The HY default rate measures the percentage of companies with “junk” credit ratings that failed to meet debt obligations during a trailing 12-month period. Default rates move with the economic cycle as they increase in times of recessions and fall in times of economic booms.
Graph 4: European High Yield default rate
0% 2% 4% 6% 8% 10% 2004 2006 2008 2010 2012 2014
Source: JPMorgan Q2 2015 Guide to the markets, NN IP (2004-2015)
Historically, the HY 12-month default rate has shown an average of 3% with a recovery rate of 30%. After rising to 8% in 2009, the default rate has quickly dropped below its long-term average in line with the economic recovery.
Moody’s Investors Services2 calculated in January 2015 that the
trailing 12-month global speculative-grade default rate finished Q4 2014 at 2.1%. In the US, the speculative-grade default rate increased to 1.9% in Q4 2014 while in Europe it fell to 1.6%. Based on its forecasting model, Moody’s expected the global speculative-grade default rate to increase modestly, to 2.7%, in 2015. By region, Moody’s expects the default rate to rise to 2.8% in the US and to 2.3% in Europe.
The low default rate in Europe can be first explained by the current economic environment of a moderate global recovery with strong corporate earnings and cash flows which are seen as positive for high yield companies.
Default rate can also depend on the ability of HY companies to borrow from banks. Ultra-low interest rates have allowed corpo-rate borrowers to lock in cheap credit for the long term. Moody’s said issuance of HY debt in Europe in the first quarter of 2015 was €36 billion, up compared with the same period of 2014. There was also a rise in the number of issuers borrowing for eight to ten years rather than the usual six or seven. The longer the maturity, the less vulnerable the borrower is to a sudden increase in risk aversion.
Graph 5: European HY bond maturity profile (bn EUR)
0 5 10 15 20 25 30 35 40 45 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Source: Barclays Research, NN IP (February 2015)
Besides the positive and monetary macroeconomic outlook, the default rate on HY bonds is also expected to remain low as many companies have used the large investors’ appetite for HY bonds to prepay outstanding debt rather than to finance acquisitions or leverage buy-outs. As a result, the HY debt market faces a very low amount of maturing bonds in the coming two years which supports the outlook that default rates are expected to remain low for the next two years.
Besides the default risk, HY corporate are also subject to credit events which can be defined as sudden and tangible (negative) changes in a borrower’s credit rating. A credit event brings into question the borrower’s ability to repay its debt. The impact on bond prices of a credit event can in many instances be much larger than that of a credit default. Rating agencies have been revising their ratings on companies upward in 2014, which
2 http://www.moodys.com/researchandratings/research-type/default-recovery-
and-rating-transitions/003009/-/-/-1/0/-/0/-/-/en/global/rr
suggests a lower likelihood of default. The improvement was particularly strong for EU firms.
Graph 6: S&P up/down ratio in %
0.00 1.00 2.00
1999 2004 2009 2014
USA Western Europe Asia ex Japan
USA Western Europe Asia ex Japan
Source: Bloomberg, NN IP (April 2015)
How do HY corporate bonds behave in the investment
cycle?
The link between spreads and default implies that a correlation can be drawn between the performance of HY bonds and the economic cycle.
Graph 7: Investment cycle
Economic DownturnBoth Equity and Credit DOWN
Mature Bull Market
Equity UP Credit DOWN
Balance Sheet Repair
Credit UP Equity DOWN
Investment Cycle
Economic Recovery
Both Equity and Credit UP
Source: NN IP
In a long and deep economic downturn, corporate profits and stocks dividends are likely to disappoint. Defaults increase. Rating agency downgrades increase. Credit, including HY bonds and equity markets take a plunge.
Faced with lower profitability and risk of further downgrades, companies become more conservative and start to focus on repairing their balance sheets and reducing their debt levels, which will lead to improved credit fundamentals. This suggests that while profits and dividend are still declining, debt is becoming more attractive than stocks for investors. This is the phase called “balance sheet repair” where credit outperforms equities. Once the economic recovery sets in as in the current market situation, profits and upgrades increase while defaults decline, boosting both asset classes.
Outlook for European HY: High expected returns…
In the first quarter of 2015, the European high yield benchmark returned 3.02%, on the back of supportive central bank policy and abating fears of an imminent Greek exit. In March new issuance reached a monthly record as companies used the historically low all-in financing cost to lock in their long term funding at attractive rates. The large bond supply weighed on the market, bringing the ECB quantitative easing induced rally of February to a halt. Many HY companies reported their quarterly results in February. The majority of the companies reported better numbers than consensus expectations. Moody’s confirmed the strong corporate liquidity position of European HY companies by sending out research showing that liquidity for these companies has reached another all-time high.NN IP currently keeps a positive outlook for European HY bonds as it believes the asset class still offers an attractive yield and a better risk/return profile compared to other fixed income investment alternatives.
Graph 8: Yields of fixed income asset classes
0 2 4 6
Cash 10-Y Bunds EUR IG Credits S&P 500 10-Y T-Bonds US IG Credits Global REITS Emerging debt Global High Yield
Source: Bloomberg, NN IP (31/03/2015)
The European HY bonds benchmark currently offers a yield of 4.4%, which compares attractively with those yields offered on other fixed income asset classes and equity.
The current economic environment can be described as one of moderate recovery with low inflation in developed economies. Global growth rates around 3% remain supportive for credit, but leave little room for errors.
The Eurozone economy is still burdened by several imbalances such as balance sheet problems in some sectors and the need for improvements in Italian and French competitiveness and profitability. On top of this there is the immediate issue of how to deal with Greece where the attitude of the new government has become increasingly counterproductive. Despite these issues, there are plenty of reasons to become more optimistic from a cyclical perspective.
Economic data in the Eurozone are clearly on an upward slope, helped by lower energy prices, a weaker euro and ultra-low inter-est rates. The services sector continues to lead the way. With the help of a weaker euro and cheap energy, Eurozone manufacturers are also increasingly contributing to growth. Another encouraging sign that the outlook for the Eurozone is improving is the return of growth in loans to households and non-financial businesses – after two years of contraction. These data are consistent with a GDP growth rate of 0.4% for the first quarter of this year while a modest acceleration in the reminder of the year is also likely. The ECB president Mario Draghi stressed in April 2015 that the ECB would continue to buy assets at the current rate until it is confident enough that inflation will be back to its close-to-2% target within a reasonable time frame. Taking into account the current low level of inflation (the core rate stood at 0.6% in March), we believe that the ECB will keep purchasing financial assets at a pace of €60 billion per month for the next year and a half at least and that short term interest rates will remain low until 2018.
Issuance of HY bonds is expected to be strong in 2015, but investor demand is likely to remain supportive for HY bonds. Considering the strong fundamentals, a 12-month return forecast for European HY bonds could be estimated at 4.4% (the current yield) minus a 1.5% default rate (with a 30% recovery rate) plus a marginal spread compression. That leaves the expected return for the asset class at 5.0% to which one can add some additional alpha generated through a bottom-up selection process.
Table 3: Next 12 Months EUR HY Return Forecast
Carry yield to worst 4.4%
Losses from Defaults
Defaults 1.5% Recovery rate 30% Loss -1.1% Spread Change Exp. Change -0.5% Duration 3.6 Performance 1.7%
Interest Rate Change
Expected change 0.00% Duration 3.30%
Performance 0.0%
Forecasted total return next 12 months 5.0%
Based on ML HPS2 Index (European HY ex Sub Fin, 3% cap) As of 30 April 2015
…but not without risks
We think that this expected return of 5.0% on European HY is attractive and compensates for the higher risk and volatility incurred. Risks to the asset class are mainly linked to substantial rises in sovereign bond yields and the default rate.
A risk linked to a pick-up in global interest rates is in theory quite lim-ited as HY bonds display relatively low interest rate sensitivity. This means that the expected spread compression makes HY bonds more resilient to an unexpected rise in government bond yields. In addition, the duration of HY bonds is shorter (around 3.6 years) than that on traditional sovereign bonds (around 6.3 years) which also reduces the exposure of HY bonds to changes in interest rates. Concerns could arise if investors leave the asset class as they become afraid for an increase of the default rate. The risk of growing defaults would materialize if the global economy growth rate suddenly fell significantly and/or if the Eurozone fell into a scenario of a double-dip recession in 2015. These are not NN IP base scenarios.
Another risk of default could be linked to special circumstances, such as the fall in oil prices caused for US energy companies, but we see no fundamental reasons for this in Europe at this stage. Further, an excess of HY bond issuance linked to a surge of lever-aged buy-out (LBO) transactions as happened in 2006 could be a risk. However, recent data show that issuance for LBO purposes is currently less than 5% of total issuance against 40% in 2006. More information on the European HY issuance activity in annex 3 on page 8.
Low liquidity: Threat or opportunity?
The low liquidity environment in HY bond markets has attracted some attention recently. This can first be seen a as a result of the significant flows into the asset class in recent years, which meant that many HY asset managers have seen a steep increase in assets under management. As the average bond size and portfolio diversification haven’t changed much, this means that asset man-agers tend to hold a larger portion of any given bond issue than before. The low liquidity can also be viewed as the consequence of the large increase in the number of issuers, which makes it more difficult to keep track the credit trends of individual issuers. The typical “herd behavior” of ever more present non-dedicated investors in HY further compounds the issue. Altogether, this creates ideal conditions for renewed bouts of increased volatility and reduced liquidity in the market. Finally, we also note that investment banks haven’t been able to meet asset managers’ increased liquidity needs as more stringent regulation and increased capital charges have reduced banks’ ability and incentive to take proprietary positions. This is also having a negative impact on market liquidity.
The NN IP European HY team deals with liquidity risk systemati-cally and pragmatisystemati-cally as it believes that will also allow it to create value-enhancing opportunities for its clients. The team distinguishes between two different types of liquidity: portfolio liquidity and market liquidity. Portfolio liquidity risk refers to the risk of having to incur material trading cost when servicing clients’
subscriptions or redemptions. Market liquidity risk in turn refers to the ability of executing a trade in the size and at the price level close to the quoted bid.
When dealing with portfolio liquidity risk, NN IP aims to avoid forced trades as these are almost always value destructive. Portfolio managers also continuously scan the market for oppor-tunities that allow them to be on the other side of such forced trades, helping them to tap into significant value potential for our clients. To achieve these goals the managers use various strategies such as holding above-average cash balances in our portfolios, investing a part of our portfolios in short-dated bonds and diversifying our holdings over several instruments with similar payout profiles to minimize any potential impact on trading costs. Market liquidity risk can be dealt with by quantifying the relative and absolute exposures to the different liquidity segments of the market, both in market value and in risk terms. Experience shows that liquidity is better for larger bonds, bonds of large issuers, issuers with more research coverage, higher-quality issuers, and bonds that were more recently issued. Our managers take all of these characteristics in consideration when deciding on the optimal portfolio profile. The primary factor is the direction of the trade. Market liquidity comes and goes, but it will be there for the investor who wants to go against the direction the market is moving, i.e. act in a contrarian way. NN IP managers like the latter trading style as a source of alpha. Finally, their bottom-up analysis enables them to build conviction for their investment cases and “stick to them” even in volatile markets.
In short, NN IP thinks liquidity risk can be dealt with in an oppor-tunistic yet calculated way so that it also serves as an additional source of alpha while at the same time protecting its clients’ assets from liquidity-risk events.
Investment implications
Even though HY bonds are traditionally considered fixed income instruments, they share more characteristics with equities than with the traditional fixed income products. HY bonds can enhance the return/risk profile of a portfolio as a way to diversify the fixed income part of a portfolio with a low correlated asset class. An active European HY fund, like NN (L) European High Yield offers a convenient way to minimize transaction costs compared to a pas-sive strategy. There are around 350 issuers in the European HY index, that need to be acquired in a passive strategy, also on the secondary market where liquidity is poor and spreads and fees are high. An active HY fund can have far fewer issuers (only 45-75 issu-ers in the NN IP fund) and therefore keeps transaction costs low. The search for yield has become a new paradigm of the financial markets. NN IP Multi-Asset team holds currently the view that European HY bonds still offer an attractive compensation for the credit risk. Although the overall yield levels are low, HY spread levels are still at fair levels. More generally, NN IP currently prefers spread products, such as European HY bonds, over sovereign bonds as credit spreads have room to tighten further even in case of upward pressure on rates.
Upside potential could be created by:
1) The ECB’s QE “trickling down” the credit curve and therefore increasing demand for higher yielding spread products. 2) Additional announcements around the depth and breadth
of EU QE.
3) Positive macro-economic development in Europe. 4) Successful fiscal stimulus in the EU.
Challenges for the HY market could be:
1) Renewed peripheral volatility (Greece, Spain), although we believe that the ECB will act as backstop for market confidence in the case of an extreme event.
2) Disappointing macro-economic news from EU.
3) Investors leaving the assets class as they become afraid for an increase of the default rate (although, aside from the US energy companies, we see no fundamental reasons for this).
4) Herd behavior with end investors in a “not so liquid” market (outflows and negative returns triggering more outflows and even more negative returns).
In conclusion, we think that relatively stable credit fundamentals, low levels of defaults, continued search for yield, attractive valua-tions and the lack of alternatives provide good reasons for being invested in the asset class.
NN (L) European High Yield won the Lipper Fund Award of Europe for best Europe High Yield fund over three years.
More information about funds is available on the NN IP website (www.nnip.com). It is recommended that readers obtain detailed information about funds before taking any investment decision.
Annex 1
Table 4: Rating Table
Moody’s S&P Aaa AAA Investment grade Aa1 AA+ Aa2 AA Aa3 AA-A1 A+ A2 A A3 A-Baa1 BBB+ Baa2 BBB+ Baa3 BBB-Ba1 BB+ Non-investment grade Ba2 BB Ba3 BB-B1 B+ B2 B B3 B-Caa1 CCC+ Caa2 CCC+ Caa3 CCC-Ca CC C C WR DSource: Moody’s, S&P
Annex 2
Table 5: European High Yield market breakdown
Credit Rating Breakdown Yield to Worst Option Adjusted Spread (OAS) BB 62.80 3.11 283 B 31.20 5.04 488 CCC 6.00 13.64 1281Source: Bloomberg, HPS2 Index (benchmark NN (L) European High Yield) Data as of 30 April 2015
Annex 3
Graph 9: European HY Bond Issuance (bn EUR)
0 10 20 30 40 50 60 70 80 90 2001 2003 2005 2007 2009 2011 2013 2015
Source: JPMorgan, NN IP (16 March 2015)
Graph 10: European HY Issuance by Purpose
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Refinancing Acquisition Dividend General Contractor Purposes LBO Other Refinancing Acquisition Dividend
General Contractor Purposes LBO Other Source: Barclays Research, NN IP (March 2015)
Disclaimer
Company names are for illustration purpose only. Company name, explanation and arguments are given and do not represent any recommendation to buy, hold or sell the stock. The security may be/have been removed from portfolio at any time with-out any pre-notice.
The elements contained in this document have been prepared solely for the purpose of information and do not constitute an offer, in particular a prospectus or any invi-tation to treat, buy or sell any security or to participate in any trading strategy. This document is intended only for MiFID professional investors. While particular atten-tion has been paid to the contents of this document, no guarantee, warranty or rep-resentation, express or implied, is given to the accuracy, correctness or complete-ness thereof. Any information given in this document may be subject to change or update without notice. Neither NN Investment Partners Holdings N.V. nor any other company or unit belonging to the NN Group or the ING Group, nor any of its officers, directors or employees can be held direct or indirect liable or responsible with respect to the information and/or recommendations of any kind expressed herein. The information contained in this document cannot be understood as provision of investment services. If you wish to obtain investment services please contact our office for advice. Use of the information contained in this document is solely at your risk. Investment sustains risk. Please note that the value of your investment may rise or fall and also that past performance is not indicative of future results and shall in no event be deemed as such. This document and information contained herein must
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