The ‘hunt for yield’ trumps value: purchase spread and returns in European high yield

This chart produced by M&G shows a link between the entry spread at which an allocation to European high yield is made, and the historic returns generated over the three years following that purchase month. In general a higher purchase spread leads to a higher return. This makes sense, as the spread compensates you for the credit risk you are taking. Also, at high spreads you can benefit from capital gains once the asset class becomes fashionable again. For example, with available spreads at between 8-10% on an asset swap basis (a swap of a bond’s fixed coupon for a floating rate coupon pegged to Libor), an investor allocating to European high yield would historically have experienced a return of between +20.46% and +47.85% over ensuing three-year periods. At lower spreads, the chance of negative returns increases. Not only does the spread barely compensate for the risk of defaults, but you are at risk of capital losses if high yield were to lose its lustre. An investor allocating to the European high yield market at a spread of between 2%-4% would historically have seen three-year returns range between -37.13% and +21.99%, for example. European high yield currently offers a spread of 2.94% which puts it in the danger zone for negative returns and so caution is warranted before dipping your toe in high yield waters. In fact, in months where entry spreads have been below 3%, there are only three occasions (of 23) where returns over the following three-year periods have been positive. The good news is that while from an allocation perspective current market levels appear unattractive, there are still attractive stock specific opportunities for those investors able to analyse the underlying credit fundamentals.