Active is: Exploiting market inefficiencies

Last year...
We began the year 2018, with low single-digit return forecasts based on low default rates. While we were overly conservative with our CCC default expectations, we were very close for BB and CCC, so loss-given-defaults’ costs were marginally lower than we expected.

Nevertheless, as at early December 2018, Global High Yield (HY) had posted -0.8% returns. Around -1.5% of these returns came from US Treasury movements; while 133bp of spread widening offset the carry. In terms of credit rating, B outperformed both BB and CCC, despite spreads actually widening more; by virtue of low default rates and less duration. This was in line with our portfolio construction¹.

The biggest divergence came in terms of market; US HY returned -0.2%, Euro HY -1.27%, GBP HY -0.1% and EM HY -2.3% (with Asia underperforming LatAm). So while our Euro HY positions hurt, our structural long position versus an EM underweight paid off well¹.

Focusing on Euro HY, this was where our forecasts went awry with spreads widening 219bps in Europe and 240bps in the UK, despite YTD Euro default rates dropping from 0.9% to 0.4%.

Unsurprisingly the spread movement was driven by politics.

Italian credit comprised 17% of Euro HY market value but it generated around half the negative returns. However, we believe that the impact of Italy was more widespread than just poor performance in the construction sector. In our conversations with Asian and US investors; the political risk surrounding Italy has reduced overseas interest temporarily into the Global HY asset class, especially given the strength of the US economy. This has led to a weak technical picture where the US backstop bid for stressed credit has disappeared. We have also seen a similar impact in EM HY which had been used to boost returns but in light of Russian sanctions; and political risk in Turkey, Argentina, Brazil and Mexico, the benefits of yield enhancement lost their appeal to HY buyers.

The knock-on impact is that we are seeing exaggerated price movement when a company has weak results. In Europe 126 bonds lost more than 10pts of value versus only 46 that saw price increases out of a universe of 661 bonds. Whilst some of the moves were entirely justified, a number appear overdone and could provide opportunities. To put these moves in context, the European distressed ratio has jumped to 9.2% from 2.7% in December 2017. Over the same period the US distressed ratio has moved from 6.1% to 6.6% and in EM from 2.7% to 12.9%; and remember this is despite the respective default rates being 0.9% and 1.1% in Europe and Asia compared with 2.1% in the US.

Looking forward to this year…
Our AllianzGI research team has carried out its 2019 expected default rate study and expects just a marginal increase in defaults in the coming year, with the US still outpacing Europe by virtue of its lower rating: BBs comprise 72% of Euro HY versus 47% of US HY. If our default predictions are correct, it does appear that non-US HY is pricing in over 100bp more than expected loss given defaults loss-given defaults plus the High Yield risk premium.

Using another metric, looking back historically, Euro HY has typically traded c. 50bp wide to USHY despite higher credit quality and this is exactly where spreads are today. So it is hard to say spreads are compellingly cheap in Europe; but if we see further widening and one can live with mark-to-market volatility the investment case becomes increasingly interesting. For a dollar investor the yield pickup post hedging of c. 3.25% from euros to dollars makes the European asset class interesting (8.1% vs 7.3%). If one strips Italy from the numbers, Europe offers 7.9% versus the lower-rated US, really highlighting some of the contagion we have seen. Of course, while Europe has political risk, it has minimal exposure to energy if that becomes a significant issue again.

“EM countries should see more positive growth momentum than developed nations” – IMF forecasts, 2018

Turning to EM HY, the discount demanded versus the US has been a lot more volatile and on average has been c. 250bp versus the 100bp seen currently. Nevertheless according to IMF forecasts EM countries should see more positive growth momentum than developed nations so there could be some areas of interest. However, as is the wont of EM, returns will be broadly driven by Chinese property and political developments in Turkey and Latin America.

EM HY yields 8.3% so the spread cushion is attractive for names that have sold-off due to concerns over asset class, rather than political concerns.

Moving towards credit fundamentals; we note that recent leverage statistics continue to look reasonable in most spots around the world and refinancing risk remains limited.

Indeed in 2019, the majority of refinancing risk is in BB; although in 2020 CCC refinancing risk seems to step up. As the market typically looks around a year ahead; market volatility has recently impacted CCC the most, as participants assess default rates if the market does not reopen. A further-on factor has been the volatility around oil prices, and the knock-on impact for the soundness of high cost exploration and production (E&P) players, as well as deep sea oil field services. A further point of note is that the numbers of the third quarter of 2018 appeared in many cases to be as good as it gets, and our research team suggests that company forecasts for 2019 are more subdued (although few, if any are calling for a recession).

“Our interpretation is that if fundamentals (and global growth) are peaking; investors need a valid reason to increase allocations to high yield”

In our view, if fundamentals and global growth are peaking, this is likely to be valuation-driven. The global high yield index currently yields 7.04% (+486bp) – this is a substantial back-up from 5.25% (+354bp) at the end of the year 2017. If we assume the 3.2% default rate is correct, the spread required for loss-given-defaults (35% recovery) is c. 210bp. If one adds the “unknown premium” of 300bp needed to invest in HY we get 510bp.

As we know HY spreads typically overshoot theoretical spreads, we could see spreads widening to 550bp. For a Global HY index, this suggests:

• 7.04% yield
• -2.56% spread-widening
• -2.08% loss-given-default
• 2.40%².
  
  

This return assessment is broadly in line with the return assumptions for 2019 published by investment banks.

Unfortunately, this return is below the yield of the US 10 year Treasury; whose return will depend on rate assumptions – nevertheless if one can add alpha by avoiding defaults or the worst of the spread-widening, net returns can still look reasonable.

For those investors who have reduced HY exposure – if we are correct and spreads do widen to 550bp, the entry point becomes more exciting:

• 7.68% yield
• -0.00% spread-widening
• -2.08% loss-given-default
• 5.60%.
  
  

Thus we would not be surprised that if spreads widen beyond 500bp we may see some new nibbling in the asset class.

A naysayer may point out that spreads forecast default a year out – and thus we should look at 2020 not 2019. There is some merit to that argument, but as refinancing risk in 2020 remains subdued and is still dominated by BB credit, we would expect default rates to remain on the low side.

By 2020 however, the market is likely to begin to question the step up in B and CCC refinancing risk in 2021. If this is accompanied by an economic recession, we would expect the pattern of spread-widening to continue.

However, as shown in the examples above, this will also be accompanied by an increase in spread cushion (and perhaps by then, a positive return from the Treasury component?) which should be supportive. To mitigate some of this risk, active selection and a potentially more defensive stance may help.

We are comforted that the market has started to reprice the global slowdown we are anticipating, hence providing opportunity to re-enter the market at spreads above 500bp, during 2019.

We also note that since 1998 global high yield has never posted two years of consecutive negative returns.

1) Source for all performance data: Bloomberg/ICE BofA ML
2) Return assumptions source: Allianz Global Investors.