European High Yield: What's Left for Investors?

NEW ISSUERS

New issuers offer a good way of finding fresh opportunities in European high yield markets. Around one in every three companies that brings a new deal to the primary market has never done so before. This is a trend we expect to continue as tighter bank lending standards drive companies to the public markets for their financing needs. Investors should not shy away from these new issuers, as they help broaden and diversify the asset class’ opportunity set. Moreover, first-time issuers typically pay higher premiums. That does not make them all attractive though as credit intensive research is required to identify the successful stories. Looking at a company’s credit quality, cash flow and management structure is a good starting point, but the assessment should not end there. The issuer’s full capital structure alongside the maturity and liquidity profile of its debt also need to be evaluated. To get a full picture of the company and the potential risks involved from investing, all these areas must be analysed. This entails hard work, but is rewarded by higher premiums, and in an environment where yields on some eurozone government bonds trade in negative territory, such opportunities cannot be ignored.

OPPORTUNITIES IN SINGLE-B RATED ISSUERS

Investors can also find opportunities by looking beyond the BB-rated universe as more value can be found in B-rated names. Although this riskier segment of the market can suffer more during bouts of volatility, from an absolute yield and relative return standpoint it can be much more attractive. Yields are excessively low in the BB-rated sector, which is considered the safest part of the market, but in my opinion can represent a value trap as I feel investors are not being fully compensated for the potential risks involved.

CONSIDERING THE FULL OPPORTUNITY SET

We believe it is important to consider the widest opportunity set possible when selecting securities. Once we have identified an issuer we like, we then screen for the security that provides the best investment, irrespective of currency. The euro’s sharp depreciation against the dollar in recent months has made it cheaper for European corporates to raise money in dollars and swap it back into euros. As a result, dollar issuance from European-based companies is expected to increase as they take advantage of the cheaper funding costs. For investors, this adds diversity to the European high yield market and broadens the opportunities available to capture premiums, while the currency risk can be hedged back into euros.

TECHNICAL BACKDROP SUPPORTS

The overall backdrop in European high yield markets remains favourable for investing. Fundamentals are supportive with the default rate low. See figure 1 below. Encouragingly, signs are emerging that economic conditions in the eurozone are improving. This could feed through into a better operating environment and corporate profits later on in the year. The European Central Bank’s announcement in January that it is expanding asset purchases is also supportive as it ensures the low interest rate environment will continue for a prolonged period. While all these factors are complimentary for investing in European high yield, the biggest determinant of returns from the asset class will come from security selection. By casting the net wider and doing fundamental research, investors can uncover the best opportunities and be rewarded for it.
 

Figure 1. European High Yield Trailing 12-month default rate (%) From December 1999

As of 31 December 2014

Sources: Moody’s and T. Rowe Price

2015-GL-1499