Investors reacted strongly to the European Central Bank’s (ECB) announcement of quantitative easing (QE) with European high yield seeing its largest weekly inflow on record, totalling €1.03bn (2.7% of AUM), in the last week of January*. Since then a steady stream of inflows, as well as strong flows into Global and US HY, has provided a positive backdrop and helped the EHY market to a 2.1% total return year-to-date.**
However the strong flow picture is by no means the only positive technical driver for EHY. We continue to see a wave of cash returning to investors from issuer calls & tenders of high coupon bonds, equity claws following initial public offerings (IPO) and rising stars leaving the index. Rising stars is a particularly powerful theme as these issuers are often large, global companies that represent significant benchmark weights, e.g. 2-3% market value** which is roughly €5-7bn in cash terms. Following the upgrade, this cash needs to be redeployed by EHY fund managers. Over the coming months we expect additional high yield names to climb this path to investment grade, which would represent substantial cash requiring reinvestment within our market.
The story is not simply a technical one either. European corporate fundamentals, having battled against anaemic growth, look set to benefit from lower commodity prices, a weak Euro and the uptick in mergers and acquisitions (M&A). Whilst M&A is not always associated with credit improvement, we are at a point in the European credit cycle where deals are primarily being driven by strategic logic, e.g. to take out capacity or help consolidate a market. Hence we have seen a number of transactions involving EHY companies merging with or being bought by larger, higher quality peers.
Our expectation for persistently low European default rates (we see European high yield market default rates staying just below 1% for 2015) was reinforced by the recent ECB quarterly lending survey, which showed easing lending standards. Two well publicised market concerns, Greece and the energy sector, present a limited threat to European high yield given their low exposure to our market at 1.86% and 0.84% respectively**.
Finally EHY valuations in today’s low yield world also stack up. Credit spreads are wider today, at a spread-to-worst of 388bps**, than at the same time last year (370bps) despite the strong year-to-date performance. This is due to the cheap valuations in single-Bs, which trade at an attractive spread-to-worst of 533bps, more than double the spread you get for investing in BBs. Understandably people have been cautious to dip back into this part of the market given European growth concerns; however, we think Draghi’s actions will change that.
The European sovereign debt market, at €8tn, is 27x the size of the European high yield market and 114x the size of the European single-B segment***. So whilst we don’t expect much of Draghi’s cash to reach the EHY market, you only need a tiny trickle down in percentage terms to drive spreads tighter. Therefore we see European high yield as a good place to be over the coming months.
* As measured by the JP Morgan Fund Flow report.
** As measured by the The BofA Merrill Lynch Euro Non-Financial High Yield Constrained Index (HEAD): Euro High Yield Non-Financial, 3% Constrained, 17/02/15.
*** Citi Research statistics