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March 02, 2017 | GSAM Connect

The Case for European High Yield


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By James Ashley

European high yield bonds’ 9.1% 2016 total return represented a very strong annual performance for the asset class, and a dramatic reversal of steep early-year losses. While a repeat of 2016’s gains strikes us as unlikely, we remain constructive on the asset class for 2017 – here are three reasons why1

A lukewarm economy can be supportive. We think the combination of modest but positive economic growth and subdued core inflation in Europe provides a fertile economic backdrop for high-yield investors. Unlike in the US, where credit markets are in the later stages of the cycle, European corporates balance sheets are solid and fundamentals are improving. Earnings are growing, as is firms’ capacity to repay interest, while leverage has remained relatively stable and is only marginally higher than in June 2011. We expect default rates to remain low and stay around 1%.

Figure 1: Coverage ratios are improving while leverage has stabilized

European High Yield-charts-01

Source: Bloomberg, BAML Global Research, GSAM as of January 2017. Last readings are June 2016.

Monetary policy remains highly accommodative. The European Central Bank (ECB) continues to engage in “heavy lifting” with its numerous asset purchase programs. We believe that European interest rates likely will need to stay low for a prolonged period. We do not exclude the possibility that the ECB’s deposit rate may need to remain at the current level of -0.4% all the way to 2019. We think the ECB’s commitment to remain engaged in its corporate bond purchase program through at least December 2017 is another driver of robust high yield fixed income demand. Investors “crowded out” by central bank investment grade corporate bond purchases must go somewhere, and we expect them to continue to look at high yield bonds. We believe that getting paid an average nominal yield of approximately 3.5% for accepting reasonable credit risk is an attractive proposition on a risk-adjusted basis, while also enjoying yield and income that can compensate for sudden volatility episodes. Furthermore, European high yield spreads versus government bonds were more than 350 basis points as of 17 February 2017. We expect spreads to compress further this year (likely by an additional 30-40 bps), which would add to returns.

Figure 2: European High Yield stands out

European High Yield-charts-02

Bloomberg, GSAM. Data are as of 31 January 2017. Euro High Yield refers to the BofA ML European Currency High Yield Constrained Index and US High Yield refers to the Barclays US High Yield 2% Issuer Capped Index. Yields for Euro HY and US HY are Yields To Worst (YTW).

Political uncertainty can be a source of investment opportunity as well as risk. Similar to 2016, the political calendar in 2017 is full, with the expected triggering of Article 50 in the UK, the French and German presidential elections in May and September respectively and, the first year of US President Donald Trump’s administration. The results of political events are hard to predict, as is their impact on the markets. We believe policy uncertainty will fuel more volatility, increasing dispersion both across issuers and sectors. In our view, this increasing dispersion is likely to provide opportunities for credit selection. In this environment, we believe a strong focus on the issuer level and bottom-up portfolio construction will be of paramount importance in generating returns without taking on undesired and excessive risk.

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About the Author

James Ashley

James Ashley

Head of the International Market Strategy Team, Strategic Advisory Solutions, Goldman Sachs Asset Management


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