Finding value in European high-yield
For professional investors only
Europe’s high-yield bond market is deepening, with companies driven by structural change to raise capital in public bond markets, creating opportunities for smart securities selection, says Mike Della Vedova, head of European high-yield at T. Rowe Price.
What has been the evolution of Europe’s high-yield bond market?
The real change has come post the 2008-09 global financial crisis. People still think of Europe’s high-yield market as 10% of its US equivalent, but it is €400 billion ($518 billion) now, so about 40% of the total size of the US high-yield market.
All those concerns about the market being small and illiquid have become misconceptions. The buyer-base has a wider number of names to select from. We believe investors should be casting their net wider.
Why is the market growing this fast?
Banks are unable to deploy the same amount of capital to sub-investment grade credit as they were pre-crisis, plus the leveraged loans market in Europe is shrinking. It means companies have had to find alternative means of sourcing capital. That is why we have seen significant growth in the bond market.
About a quarter of the market is fallen angels, or former investment grade companies that have fallen to sub-investment grade. But the real growth is coming from companies that have not issued before.
Last year there were about 100 additional issues, of which up to a third were from first-time issuers. For managers willing to do the credit work, there is an opportunity to capture value.
What is the level of new issuance like relative to history?
Last year was a record with more than €80 billion in new issuance. Overall the market has about 570 issues for $400 billion in AUM. This year it is €75 billion already. Almost a third of this came from companies that were not bond issuers as recently as 2010. These are brand new names and that is the area that requires more work.
New issuers might represent an opportunity, but risks also?
There are two key risks. One is identifying successful stories, the other is valuing the risk. Good companies are issuing bonds rated BB with a coupon below 3%. That is yield, not high yield. I agree there is a potential value trap if you look to work close to benchmark.
However, when you look away from that, you will find some interesting opportunities. The aim is to be selective. It comes back to having the resources to assess different business cases.
At T. Rowe Price we have 12 analysts covering high yield. On top of that we have emerging markets macro and sovereign experts.
How many bonds do you maintain in your portfolio?
We look to be relatively concentrated to capture maximum value. Through the portfolio’s life I would look to have 70 to 150 issuers, versus a market that has over 330 issuers and is increasing. A large proportion of our holdings will be in the B-rated category where we see the best value for investors.
Where does Europe stand from a relative value perspective?
Europe is at a different phase of economic growth to the US and there are structural differences. The US market has seen a lot of leveraged loan issuance, so you have a different opportunity set.
We see value in European high-yield now in complex structures and in industries with new issuers coming through, such as the services sector. The big risk faced by all credit investors is default risk.
In Europe there are historically low default rates of 2%, which are forecast to go below 1.5% this year. The global average rate is 4.9%. You also have well-defined bankruptcy procedures in developed western Europe versus emerging markets, and that has to be factored in when you consider relative value.
What about average spreads for Europe versus the US?
By Bank of America numbers, the average US high-yield spread is 347 basis points (bp), and for the European index I am focused on it is around 314bp, so it trades inside by 30bp.
Broadly 60% of the US high-yield market is single B issuance, while for Europe 60% of issuance is BB. So you should see a tighter spread in Europe. But when you isolate single Bs, Europe stacks up as good relative value.
What is your thinking around governance and transparency?
What is helping to keep management teams honest is the shift in how corporates are sourcing capital in public bond markets rather than the loans market. This is not a short-term blip, it is a permanent step change.
It is not in corporates’ interests to do bond holders a disservice for a short-term potential gain because they are going to have to deal with the bond community in terms of refinancing potentially for decades.
What impact might ECB quantitative easing have on the high-yield bond market?
The market is forced to be rational because there is not excessive economic growth. I am not saying I don’t want to see a bit more economic growth. But it does support dynamics for our market.
Post crisis, sub-investment grade companies have been forced to become more conservative in how they approach the raising and spending of capital. That is good for high-yield investors.
The European Central Bank looking to do QE is positive because we want to see growth continue. The ECB has not put a lot of capital behind its policy statements, but the market realises that Draghi and co are serious and there is real firepower there.
How do you weigh risks versus the opportunities in Europe geographically?
The ability to move between countries is important. Right now we are more supportive of the UK retail economy. We are also seeing good core opportunities, with more issuance from German industrials.
We are also seeing opportunities with large pan-European issuers and suppliers that support them in central Europe, and the cable TV and mobile phone industries.
What about Eastern Europe?
We have seen increasing issuance. The key is to understand what is happening on a local basis. With our high-yield team and sovereign experts, we have visited companies in Poland, Bulgaria and Romania, meeting local banks and IMF officials to get first-hand knowledge to put opportunities into context. We do see interesting opportunities.
What is the growth profile for Europe’s high-yield bond market over the next five to 10 years?
We expect the market to reach €450 billion by the end of this year, with growth continuing at a slower rate thereafter. It will probably get close to 45% of the US market.
While absolute yields and spreads are low, market selection has led to a real difference in performance since the second half of 2012.
Increasingly it has become about individual investment selection because we are into the tail-risk of the crisis now in terms of peripherals and banks. While another crisis may come along, the seismic impact on spreads will not be the same as we saw in the financial crisis. Returns will come down to active management and individual selection.
How long has T. Rowe Price been running a separate European high-yield bond strategy and how has the performance been?
T. Rowe has been involved in European high yield since 2000 and we have run the Global High Yield Bond Fund with a dedicated European high-yield piece for more than a decade.
We have run a dedicated European High Yield Bond Fund since September 2011. It will soon reach a three-year track record.
Performance so far has been strong, with a cumulative performance of 51.80% since inception (as of 30 June 2014, I share class). When we launched the fund, we decided to take out subordinated financials to better protect investors and reduce volatility over the long term.
We have today a total exposure of $1.5 billion in European high-yield assets, out of the company’s global high-yield assets of $25 billion.
Do you see demand for European high-yield from Asia?
It is mostly from Europe, where knowledge of the asset class is. But we are getting more requests outside of Europe now. Investors who perhaps had been scared by the potential dislocation of the European Union have been coming back in the last six months.
Investors now have the benefit of having seen how different banking crises have been approached so they have some idea of what to expect. I always tell people: earthquakes don’t kill, statistically most people die in the aftershocks. We have had the earthquake and for four years now the aftershocks in Europe have been getting smaller.
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