European High Yield
Just how defensive are BB rated European high yield bonds in today's markets?
Since the launch of our European High Yield Bond portfolio back in 2011, I have always had a bias for looking beyond the BB-rated universe. The research our high yield analysts carry out to identify long-term positive stories–where the income profile is attractive and the potential for capital gains most rewarding for our clients–has found that the best opportunities often lie in the single-B rated space.Holding a structural underweight in BB-rated companies however, I often get asked whether the risk profile of our European High Yield approach is potentially higher than that of the markets. This was certainly the case during the so called “taper tantrum” episode of 2013, when BB-rated names held up much better than B and CCC-rated securities.
The second quarter of 2015 has depicted a different picture though, despite a similar environment of heightened volatility and fears of higher interest rates (see chart below). Contrary to expectations, B-rated names have resisted well in the sell-off environment (down 0.74% in euro terms*) while BB-rated securities have strongly underperformed the rest of the high yield universe, generating an absolute return of -1.43%* for the quarter.
Why? A clue may lie in looking at the spread correlation that currently exists between the European investment grade market and the BB-rated high yield sector. BB-rated securities have been strongly impacted in the last quarter by the negative performance of the investment grade corporate bond sector. This impact may well be a sign that the current market volatility is spooking a number of investment grade managers, who have in the past owned BB-rated names as simple cross-over holdings and are now reducing risk in their portfolios by selling those lower rated securities.
The second reason may well be related to portfolio management and liquidity raising at times of outflows. Keeping in mind that BB-rated securities make up a much higher proportion of the EHY market (>60%)*, they are more likely to be sold to raise liquidity when needed.
Taking this all into account really does bring into question just how defensive BB-rated securities are during periods of volatility. I remain convinced that B-rated companies offer the best investment possible for European high yield investors, particularly since holding them does not automatically raise the risk profile of our portfolio relative to the market.
* Source: BoA Merrill Lynch, as at 30 Jun 2015
2015-GL-2158
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