“The technicals point in favour of the non-government sector in particular,” says Brett Pybus, iShares fixed income strategist, Blackrock. “Investors are being pushed into other parts of the market as sovereign bond yields fall, creating a trickle-down effect.”
A look at the technical picture clearly demonstrates how hot the boiling pot will become in a relatively short space of time.
“European bonds are being driven by technical pressure,” according to Supriya Menon, multi asset strategist at Pictet Asset Management. “The ECB needs to buy three-times net issuance in Europe and roughly five-times net issuance in Germany alone. Compression of spreads on B and BB high yield bonds is inevitable as people move further down the credit spectrum as the huge loosening of financial conditions creates strong flows into high yield.”
The environment looks supportive for the next 16 months or so as long as the ECB’s bondbuying programme remains in place, which looks set to last until at least September 2016. Add to this picture the weaker euro, driven down in no small part by the ECB actions, but also by the Swiss National Bank’s decision to drop its euro peg, and the environment for European corporates looks significantly more rosy than it did last year given the economy remains largely export driven. The falling oil price lends further support to the case for continued improvement for a region that is one of the largest net importers of energy.
WHAT’S THE DIFFERENTIAL?
The impact of such massive demand on the European high yield market can only be expected to push yields in one direction – down, and this is already underway. Data from Thomson Reuters shows the price of the Markit iBoxx EUR Liquid High Yield Index has been on a strong, steady upward march since the start of the year, increasing 3% between 1 January and 10 March from €178 to €183. Meanwhile, yields on the Markit iBoxx EUR High Yield Liquid 30 Index have fallen from around 4.5% in October 2014 to around 3% by mid-March this year after dipping below 3%. Over the last three years the picture is even more dramatic. The index was trading at nearly 9% at the start of 2012 – illustrated in the chart above by the increasing price as price and yield move in opposite directions.
However, despite the fall, the differential over government bond yields means high yield is still attractive even at those dramatically reduced rates.
Patrick Zeenni, deputy head of high yield and arbitrage credit, Candriam Investors Group, points out that the differential between government and high yield bonds is actually wider than it was a year ago given the corresponding decline in government bond yields.
“The European high yield BB/B index is at 3.5% at a duration of 3.5 years while the comparable Bund yield is at -0.15% giving a differential of 3.65%. A year ago that differential was only 3% so the yield spread is much more compelling.”
Others argue even with yields falling, valuations in the European high yield market are still attractive. Pictet points to the yield pick-up currently offered in the space, saying it is more than sufficient compensation against the risk of default. According to their figures, the market implied 12-month default rate is approximately 5.7% compared to a trailing 12-month rate of approximately 2%. Moody’s expects the default rate in Europe to rise marginally from 1.7% in 2014 to 2.1% in 2015, still well below historical norms and lower than the predicted 2.7% for the US high yield market in 2015.
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