In the classic spoof “rockumentary” This is Spinal Tap, the filmmaker, Marty, notes the small concert venues into which the aging heavy metal group is booked for its upcoming US tour. He asks Spinal Tap’s manager, Ian, if this is a sign that the band’s popularity is waning. Ian replies, “Oh no, no, no, no, no. Not at all. I just think that…uh… their appeal is becoming more selective.”
Judging by European high yield’s post-Brexit performance (+2.5% in July and +6.6% YTD to 31 July)* you would be forgiven for thinking that the asset class has been performing in front of packed stadiums of devoted high yield fans. When judged by fund flow data, the reality has been quite different with cumulative net flows into EHY funds only one quarter of the level we had reached at this point last year. In fact, were it not for the money going into both the ETF and short duration version of European high yield funds, net flows would have been negative.
We can only generalize about the motives for allocating to passive or short duration funds, but it is probably fair to say that the former is more tactical (i.e., short-term) in its positioning, while the latter is looking for an oasis of positive low-duration yield in the desert of negative short-term rates. In other words, tickets have been sold either to those with an eye on the exit or to those who have nowhere to go and nothing else to do. This hardly helps to build a compelling case for the strength of European high yield technicals.
It is however worth remembering, that the fund market only captures about one third of the demand for European HY assets and is therefore only a proxy for the bigger picture. The most important overriding technical for high yield is still the one provided by central bank purchases of sovereign and corporate fixed income assets, which has pushed yields to record lows and hoarded investors into corporate credit.
As a result, and in sharp contrast to European high yield, European IG bond funds have seen five consecutive months of positive inflows since March, thus pushing down yields and expanding their capacity to add off-benchmark high yield bonds. This has been great for recent EHY returns and undoubtedly accounts for much of the outperformance of BB-rated securities. But, still missing is the hard-core fan who buys the whole album (including the B and CCC sides) rather than downloads a single tune.
The result is that there are still plenty of places to find value whether it is in GBP HY bonds vs. EUR HY bonds, B’s versus BB’s, or simply moving further out the credit curve. However, European HY will need to reconnect with its core audience if today’s investors are going to benefit from these pockets of value.
Epilogue – Fans of the film will recall that after a disastrous tour that leaves Spinal Tap on the verge of splitting up, word arrives that their latest album Smell the Glove has generated massive sales in one corner of the globe. There they must go. The closing credits roll as the band walks on stage to a sold-out stadium in Japan.
*Performance as per the BofA Merrill Lynch HECM benchmark