European High Yield - November

Why QE extension would support European High Yield

Mark the 3^rd of December in the diary. It’s the day of the European Central Bank’s (ECB) monetary policy meeting and given dovish rhetoric from its president Mario Draghi, expectations are high that new measures could be unveiled. While such an outcome is far from a done deal, if the ECB does decide to pull the trigger, I expect this to be supportive for European high yield and here’s why.

First and foremost, an announcement of new measures could help provide stability in European high yield markets. This would be most welcomed given that risk markets broadly could be prone to more bouts of volatility ahead as the Federal Reserve moves closer toward tightening monetary policy for the first time in almost a decade, and China’s economy continues to go through a multi-year adjustment program.

Another possible outcome from more easing is that it’s likely to keep yields on Eurozone government bonds low. As a result, there is potential that European high yield could benefit from increased inflows as investors seek alternatives to the low yields, and in some cases negative yields, on offer in Eurozone government bonds.

Additional easing is also likely to accentuate the divergence between European and US high yield. In stark contrast to the ECB, the Federal Reserve is mulling hiking interest rates as the US economy is further along the economic cycle. Europe is at a more credit-friendly phase with potential for growth to improve, which could feed through into better earnings going forward. Default rates are also expected to remain low in Europe, while in the US they are starting to pick up, particularly in energy names that have been pressured by the sharp decline in oil and commodity prices. As I have written about before, US high yield has much larger exposure to energy and metals and mining sectors than Europe.

In all, supportive long-term fundamentals in the asset class remain intact. In fact, even without additional easing under the ECB’s current quantitative easing program, the central bank is buying a huge amount of Eurozone government bonds each month. So much so that net bond issuance after the ECB purchases is expected to turn negative in the final quarter of the year, as illustrated by Figure 1. With demand outstripping supply, Eurozone government bonds are likely to stay low, pushing investors further down the credit curve, potentially into high yield.

Taking all this into account, it’s evident that the asset class has a number of supportive features at present. From a portfolio perspective, we continue to focus on bottom-up credit research to uncover the best opportunities for our clients, while managing downside risk. This approach has led us to be overweight in the single-B rated segment of the market, where we have a preference for bonds with high coupons and shorter-dated maturities as price volatility is more contained.

Figure 1: Quantitative Easing Remains a Powerful Factor
As at 30 September 2015

Sources: JP Morgan, ECB and T. Rowe Price

2015-GL-2939