European High Yield vs. Eurozone Tail Risk High Yield

As Eurozone concerns have dominated risk appetite within the market this year, a key question that faces many market participants is how to capture some of the attractive risk premiums that this weakness creates without exposing themselves unduly to the significant “tail risks” of a full blown Euro death spiral.

In this vein, a popular trade in recent months has been to add exposure to the US high yield market. The rationale is fairly simple (and one that we agree with): The US high yield market is trading at reasonably cheap levels, yielding 8.6% with a spread over treasuries of 754bps*. Yet at the same time the US economy is performing much better than Europe, its government can borrow cheaply and you don’t suffer from all the inherent tail risks of the European markets.

There is no doubt that issuers within the European high yield market are exposed to the economic headwinds that the Eurozone has created. However, is it fair to label the market as one that is riven with tail risks? We’d argue it isn’t.

The chart below splits the high yield market into different regions according to the geographic centre of gravity for each issuer. “Core Europe” encompasses German, French, Dutch, Austrian and any other current Eurozone country that has avoided the “Peripheral” tag. This area, arguably less exposed to true tail risk events (i.e. a Spanish and/or Italian exit from the Euro) accounts for just under half of the market at 47.58%. The “Peripheral Europe” issuers, or the real “tail risk” within the market, accounts for around 16% at current trading levels. Let’s put this another way:  84% of the market is not directly exposed to a major tail risk event.

Probably more surprising is the proportion of the market that operates entirely outside of the Eurozone. Taken together, Western European Non Euro (i.e. UK, Swiss, Swedish, Norwegian issuers), Eastern European, North American, South African and Asia Pacific issuers account for a little over 36% of the market.

Also, when we focus on the European map of issuance below, the country by country specifics of the market are easier to determine. Taken together German, French and British issuers account for 51% of the market.

The point is this – there is no doubt that there are many risks within the European high yield market (volatility, economic headwinds, the likelihood of rising default rates), but we believe there are still many pockets of opportunity where investors can capture some attractive risk premia without directly exposing themselves to catastrophic European “tail risks”.

*Source: Bloomberg, Merrill Lynch US High Yield Master II Index, 20th December 2011

Discuss Article

  1. Justin Pugsley says:

    The big concern with investing in high yield Eurozone corporate bonds goes beyond just break-up. They have agreed a set of fiscal principles, which pretty much guarantee austerity for years to come for much of Europe.
    I reckon even Italy, now subject to yet another round of austerity measures under its new government, could go the way of Greece, which has had four years of recession or even depression. Can weaker corporate credits survive this kind of environment? Even France and Spain look vulnerable as they pursue yet more austerity measures, which could lead to deep economic contraction.
    It feels like the Eurozone is going through a self-defeating downward spiral of fiscal austerity, which kills growth, to be met by more austerity, which makes it harder for debts to be ever paid back – corporate or otherwise.
    Eurozone countries have for all intents and purposes adopted a foreign currency presided over by an anti-inflation fanatical central bank and one where fears over moral hazard seem to guide its actions. All very fine sentiments, but not very helpful in the teeth of a raging crisis where the ECB only very reluctantly acts after the problem has escalated to very worrying levels.
    Austerity is great if everyone else isn’t doing to, done in relative isolation it can work well, But doing it all together can have disastrous consequences. It’s a bit like everyone deciding to become savers rather than spenders at the same time. I suspect the US, after elections next year, will also pursue austerity measures.
    For this reason I doubt the UK will balance its budget for decades now and this makes for a tough environment in which to invest in high yield corporate debt, which tends to be just investment grade or below and therefore more vulnerable to economic conditions.
    I think a time may come when the western world will have to consider a new growth pact, but for now we’re all obsessed with balancing budgets, just like in the 1930s! 

    Posted on: 22/12/11 | 10:25 am
    • James Tomlins says:

      I entirely agree with you on the point that austerity creates very severe conditions for high yield companies. This is something that we are very aware of and, accordingly think the best risk/reward within Europe are for more defensive businesses that can survive a low /negative growth environment. Also, we need to remember that some European countries are still expected to show positive real GDP growth over the next two years despite all that is going on around them (Norway & Sweden for example). Its with this in mind when I talk of “pockets of opportunity”.

      Posted on: 22/12/11 | 11:18 am
  2. L. C. Chong says:

    Is there any correlation between Euro high yield and EUR/USD or stock market?

    Posted on: 29/12/11 | 2:25 am

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