Almost everywhere you look yields are low. It was therefore somewhat of a surprise this month when a respected US fixed income investor singled out the European high yield market. Referring to a chart that compared Europe’s sub-investment grade corporate bond yields to 10-year US Treasury bonds, the portfolio manager tweeted that it’s ‘wacko season’ for European junk bonds. Soon thereafter European high yield seemed to be all over the headlines which prompted several colleagues to ask, “Should we be worried?”
The answer is “yes” and “no”: Yes, we should all be worried about how a 140-character tweet can become instantly newsworthy and therefore seemingly credible; and no, we should not be particularly worried about the relationship of European junk bond yields to the 10-year US Treasury.
In all fairness, I can understand how a quick glance at a chart depicting the emblematic risk free asset with the same yield as a speculative grade corporate bond index could elicit gasps. However, a less reflexive and more measured consideration of the two converging lines should lead to the conclusion that the only thing ‘wacko’ is the chart itself. It’s almost like comparing the brainwaves of a potato to a rock and on that basis concluding that potatoes are intelligent. The first thing to do before reaching for Twitter is to recall that the yield on the high yield asset class consists of both an interest rate component and a spread component.
First, European high yield is priced off of a euro rates curve and anyone following global fixed income markets knows that rates in Europe are a lot lower than in the US. At present, the 10-year German bund at 0.40% is a full 1.8% lower-yielding than the equivalent maturity US Treasury bond. Second, comparing the European high yield bond market with its average time to maturity of less than five years to a 10-year fixed rate government bond, whether issued by the US or Germany, is inappropriate. The 10-year bund yield is currently 40bps, which is nearly 70bps higher than the 5-year bund yielding -29bps. Third, switching between a USD-denominated fixed income asset into a European one or vice versa entails taking currency risk. Eliminating that risk with a cross-currency basis swap would shave almost 2% off the yield of the US Treasury bond. You simply cannot make a fair comparison between a 10-year Treasury and a shorter duration asset class priced off of a euro interest rate curve.
There is no question that declining European credit spreads have played some part in bringing the European speculative-grade bond market’s yield to the same level as the 10-year US Treasury. In fact, the current option adjusted spread of 275bps on the European HY benchmark (BofA ML HEC0) is at its lowest level since the global financial crisis. But, the current spread level is wholly justified by what are arguably the strongest credit fundamentals in the 20-year history of the European high yield market. The benchmark’s default rate is less than 1%, the European macro picture is strong with GDP growth outpacing the US, political uncertainty has abated, and high yield corporates are still de-leveraging. Furthermore, you simply cannot compare today’s European high yield spreads with past levels without accounting for the fact that 70% of the market is now BB-rated. As our own Iain Stealey pointed out a few weeks ago, were you to re-weight the market with the longer duration and lower average credit quality of the market at its all-time tights in 2007 (when less than 40% of the market held BB ratings), the current spread would be more than 90bps wider than it is today.
If yields for European sub-investment grade bond yields look extreme, this is almost entirely due to rates and not spreads. If rates look extreme, then putting your money in an asset class with less than half of the duration of a 10-year US Treasury plus significantly positive carry, and a tendency to perform well when rates start to rise, does not look so wacko after all.