Investors are diving into European high yield corporate debt with gusto, and the feeding frenzy shows no signs of slowing. Issued by companies with below investment grade credit ratings, high yield bonds (also called “junk bonds”) represent one of the fastest-growing areas for European open-end funds and ETFs. Assets under management have grown from €12 billion at the beginning of 2009 to €57 billion in April 2014, according to Morningstar data.
Does this mean that investors should shun the high yield market?
That’s partly because the market itself has grown, thanks to structural changes in the marketplace. Unlike their US counterparts, prior to 2008 most European issuers with credit ratings of BB or below preferred to obtain financing privately from banks rather than issuing debt on public markets. However, that pattern has changed dramatically since the financial crisis.
More stringent capital requirements under Basel III have prompted banks in Europe to cut back their corporate lending, forcing many lower-rated companies to borrow on public markets for the first time. At the same time, the spate of sovereign downgrades that hit Europe starting in 2010 has pushed many formerly investment grade companies into “junk” territory, further swelling the ranks of high yield borrowers. Since the end of 2008 through May 2014, the European high yield market has grown from roughly €40 billion to more than €320 billion.
Still, as quickly as high yield bonds have proliferated the European marketplace, demand has grown even faster than supply. With central banks around the globe keeping short-term interest rates minimally low to encourage economic growth, many investors have pushed into dicier areas of the market in search of more attractive risk premiums.
Since 2013, emerging markets debt, formerly the favoured source of risk for European investors, has also lost much of its lustre, redirecting even more capital into high yield corporate bonds. During the 12 months ending on April 30, 2014, funds domiciled in Europe that invest in emerging markets debt saw €14.5 billion in outflows, while those investing in European high yield corporate debt saw €12 billion in inflows.
So far, investors in European high yield debt have been richly rewarded, too. The typical open-end fund in Morningstar’s EUR High Yield Bond category returned an average of 13.6% annually over the last five years. That’s an enviable record, especially considering that the global bond category returned just 5.5%.
However, there are good reasons to approach the high-yield market with increasing caution. For one thing, it’s not likely that those spectacular gains can be repeated. The head-turning outperformance delivered by high-yield funds over the last five years has derived primarily from dramatic yield drops since 2008’s historic highs. Average yields on high-yield bonds peaked at more than 25% at the height of the financial crisis. In May 2014, they were back down to 4.2% (lower than the pre-crisis yield on the German 10-year Bund in mid-2007). To give an example of how slim the risk premium on junk debt has gotten, the troubled Greek bank Piraeus, which boasts a “speculative” CCC rating, was able to issue a three-year bond in March 2014 with just a 5% coupon, thanks to aggressive bidding by yield-hungry investors. With yields already this low, there’s just not much room left for them to fall further, even if demand does continue to outpace supply.
Another cause for trepidation is the fact that, as many managers have pointed out, the level of risk in the high yield market has begun to grow even as risk premiums continue to shrink. For one thing, European high-yield issuers are beginning to use the proceeds of their borrowings less to refinance existing debt at lower rates and more to fund aggressive activities such as mergers and acquisitions.
In 2013, high yield borrowers spent roughly €10 billion, or 12% of their borrowings, funding mergers and acquisitions. In the first five months of 2014, that number was €15 billion, or one third of their borrowings. That’s a number investors should keep an eye on, because expansionary corporate activity can potentially put a dent in a company’s future creditworthiness.
Another phenomenon managers have pointed to with alarm is the deteriorating quality of covenant protections on the European high yield market. In the context of high yield investing, covenants refer to legally binding promises made by issuers that place limits on the types of activities they can carry out. These typically restrict the amount of additional debt an issuer can take on, or the amount of cash the company can spend to pay dividends to stockholders, ensuring that the company stays in good enough financial shape to service its existing obligations. Increasingly, companies have been able to sell high yield bonds to investors without these protections built in.
In fact, some of the most popular products on the high yield market this year have been those offering the least protections to investors. So far in 2014, European banks have successfully issued roughly €7 billion in contingent convertible bonds, or “CoCos,” a new type of hybrid debt issued by banks. CoCos convert automatically to equity, or are written down, when the issuing bank’s tier 1 capital ratio falls below a specified level. Thus, they combine the upside risk of a fixed income instrument with the downside risk of a stock. Demand for the instruments has outpaced supply; Deutsche Bank reportedly received €25 billion of orders for €1.5 billion in BB rated CoCos it issued in May 2014.
Does all this mean that investors and advisors should shun the European high yield market completely? Not necessarily. Because of their lower sensitivity to interest rates, many advisors continue to see high yield bonds as a valuable component of a well-balanced portfolio, especially given the prospect of a future rise in benchmark rates.
Still, when seeking exposure to the European high yield market, selecting a good manager is of paramount importance. In this space, Morningstar places particular emphasis on fund managers’ research capabilities. That’s because, in Europe, many high yield issuers are still new to the market and public information about them can often be scarce. We also think it’s important that the manager and analysts have experienced multiple credit cycles and have the resources to dig into the details of debt contracts. Perhaps most importantly, we favour managers who resist the urge to sacrifice risk management for big pay-outs, even when the prevailing trend is to stretch for yield.
HSBC GIF Euro High Yield Bond and Raiffeisen-Europa-HighYield, which both carry a Morningstar Analyst Rating of Silver, boast managers who have been around for more than a decade, as well as large credit analyst teams. In addition, both management teams have a history of pulling back when they think the markets have gotten too frothy. Recently, for example, both funds have treaded lightly in the lowest-quality, CCC rated corner of the market where yields, and credit risk, are the highest.
Even when placing a client in a trusted fund, the importance of setting expectations and clearly explaining the risks involved has never been greater. The outsize returns investors saw in 2009 and 2012 likely won’t be back for quite some time, while the market’s pitfalls have grown more numerous.
