European High Yield

Recent performance in high yield – it’s not all about oil this time.

The thawing of Greek concerns helped the European high yield bond market generate positive returns in July. Spreads tightened, inflows returned, and an abundance of new bonds were issued in the primary market. What’s more, for the first time since March, European high yield bonds outperformed their U.S. counterpart, which generated negative returns over the period. Why the divergence?

The sell-off in oil prices during July certainly didn’t help. In U.S. high yield, energy is the index’s largest sector weighting, making up almost 14%¹. This exposure makes it more vulnerable to moves in oil prices than European high yield, because energy issuers constitute just 5%² of the benchmark here. In another divergence, the U.S. share is made up of lots of smaller energy companies which tend to have lower ratings, while Europe comprises of large ‘fallen angels’ names such as Gazprom and Petrobras, which have dropped down from the investment-grade universe into the junk bracket.

Cast your mind back to the second half of 2014 and you will remember that the precipitous drop in oil prices during that period lead to significant underperformance of U.S. high yield relative to Europe. This time though, it’s about more than just the downturn in oil. The metal and mining segment of the U.S. index generated an absolute return of -8.6%³ in July. This was driven by the sharp decline in metal prices, such as copper, which plunged to a six-year low during the month on concerns about China’s demand slowing. Once again, the U.S. high yield market has a bigger weighting of metal and mining companies (excluding steel), which take up around 3%¹ of the index compared with Europe’s 0.44%².

These weighting disparities resulted in less volatility in Europe during July, which helped outperformance versus the U.S. Can this trend continue? That depends on how long this downturn in commodities and oil prices lasts.

On our side, we continue to focus on bottom-up credit research where we can find the best opportunities to add value for our clients but also where we get some protection against external shocks. With the consequences of a weaker China unknown however, investors should prepare for more turbulent markets and given the composition of European high yield, it may not be a bad place to invest.

Figure 1

¹ BofA Merrill Lynch US High Yield Index

² BofA Merrill Lynch Euro High Yield Index

³ BofA Merrill Lynch US High Yield Metals & Mining Index

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