Since the start of 2011 we have seen the onset of the Eurozone crisis, endemic political uncertainty, a return to recession and a de facto Greek sovereign default. Contrast this to the path the US has taken with aggressive QE, positive growth and a recovery in the housing market. The somewhat surprising fact is that in spite of all this, the European high yield market has outperformed its US counterpart, returning 29.0% and 24.8% respectively*.
There is little doubt that the US presents a more benign fundamental and macroeconomic environment for leveraged companies. Nevertheless, there are still compelling reasons to believe the European market offers the better investment opportunity. Here are 5 reasons why:
- Lower sensitivity to interest rates – since the genie of “Tapering” has been let out of the bottle this summer, investors have become acutely aware of the interest rate risk inherent in their holdings. The European high yield market has an effective interest rate duration of 3.2 years compared to 4.4 years for the US. Accordingly, the European market will be less sensitive to a further sell off in government bonds all other things being equal.
- Lower average cash price – European high yield bonds trade with an average cash price of 101.98 with the US at 102.92. This may seem like a small difference, but given the presence of call options in many high yield bonds, a cash price above 100 indicates limited scope for capital appreciation. The European market suffers from the same constraint, but with an extra 1% of headroom.
- Higher quality market – viewed through the prism of credit ratings, the European market is lower risk. BB rated bonds make up 67% of the market compared 42% for the US. Higher risk B rated bonds make up 23% and 41% respectively with the remainder within CCC’s. This means two thirds of the European market is rated just below investment grade, whereas over half the US market is well into “Junk” territory with a B or CCC rating.
- Higher credit spread – the European market as a whole trades with a credit spread over government bonds of 508bps compared to 471bps in the US. When controlled for credit rating, the difference is even more stark. European BB rated bonds trade at 410bps over sovereigns with US BB’s at 342. The numbers are 607bps and 454bps respectively for B rated instruments. We know the European economy is struggling but this is already factored into valuations.
- Lower default rate – According to Bank of America Merrill Lynch statistics for the public bond markets, the trailing last 12 month issuer weighted default rate for the European market is 1.2% compared to 2.1% for the US. There is little to suggest that this trend will dramatically change in the near future given low interest rates and supportive refinancing trends.
Of course there are always mitigating elements to this argument – the all-in yield of the European market , for example, is lower at 5.1% (US is 6.1%) – reflecting both the lower duration of the market, but also the divergence of European and US government bond market yields over recent months. Nevertheless, with lower interest rate risk, lower average cash price, higher credit quality, higher credit spreads and lower default rates, the investment case for the European market continues to look more compelling compared to its American cousin.
*BofA Merrill Lynch US and Euro High Yield Indices 31/12/2010 – 26/07/2013