For the European high yield bond market, 2016 was marked by three distinct phases and some defining moments.
In contrast to normally favorable seasonal trends, the beginning of the year saw an abrupt sell-off which lasted for the first forty days on the back of a global growth scare (hard landing in China and the US), with commodities flaring up and risky assets closely correlated to the downward movement in prices. By the end of February, macro data and stabilization in oil prices helped overall prices recover from the cheapest valuations recorded since the second half of 2012. The market kept rising almost unrelentingly until the beginning of June, when it started discounting the probability of an unfavorable outcome in the UK Brexit Referendum, before collapsing for a few days in its aftermath. At that point, the positive contribution from rates accounted for half of the high yield total return to date.
The first half of the year saw both deflationary and inflationary assets performing well, another counter-intuitive trend which is typically associated with significant inflection points. In fact, at the beginning of July we reached a peak in deflation expectations with an all-time low in interest rates, a trend that has since reversed. Should this reversal prove lasting, then it would have the potential to be the most important factor for repricing financial risk over the coming quarters. High Yield was not immune from the upward movement in interest rates, which particularly impacted BB securities, a rating category mostly comprised of corporate hybrids and the so-called ‘fallen angels’. In the BB space, the duration sensitivity was also magnified by the spread tightening due to the European Central Bank’s Corporate Sector Purchase Programme, which has reduced the spread cushion to shield from higher rates. The same concept was further stressed upon the US presidential elections, as valuations were less resilient to rising rates and steepening curves, and credit spreads could not benefit from the Trump effect to the same extent of equity markets.
This will likely lay the foundation for the 2017 outlook. As long as rotation out of deflationary assets unfolds, high yield bonds are not going to have the same tailwind from low rates and search for yield as was the case until recently. Therefore, in order to generate a meaningful excess return, it will be crucial to discern between winners and losers from a credit, bond picking and implemented strategies standpoint. In such an environment, passive and tracking error constrained strategies might suffer, while cherry picking active managers will have more opportunities. Globalization is another trend we will keep monitoring closely. Shall it continue to slow or even recede, a renewed focus on stimulating domestic demand might favor small/mid-caps over large multinational companies. This shall impact high yield bonds, while creating various investment themes within the asset class.
Due to different liquidity and lower informational efficiency compared to other financial assets, the high yield bond market has a great potential in terms of fair value misalignments (therefore potential opportunities) and actionable trading ideas.
As such, the current environment raises the case for a different and more flexible approach to High Yield, with a focus on high conviction strategies and a proactive stance in market risk management, so as to limit the exposure to downside episodes and ultimately capture the potential returns offered by this asset class.
Stefano Perin is a high yield portfolio manager at Generali Investments