The European sovereign debt crisis has changed the rules of the game for euro high-yield investors. Fixed-income managers are being challenged to think differently about both the risks and the opportunity set. And they are having to adapt to a number of shifts in the euro-area high yield landscape.
One new development is that the market’s traditional idea of financials and utilities as safe-haven sectors has been overturned. Previously, these were the go-to sectors in a “risk off” scenario, because financials and utility companies tend to be linked to the government’s credit quality. But that correlation has become problematic as sovereign risk has increased, triggering the rating downgrades of several countries including France, Italy and Spain. And these country downgrades have had a big knock-on effect on the financial sector, with a number of banks seeing their subordinated debt cut to junk status.
The second change, in our opinion, is that macroeconomic analysis has become relatively more important. With sovereign risk playing a bigger role, investors need to have a well-considered view on the health of the economy as a whole (i.e. systemic risk.) In the past, high-yield investors have typically devoted more resources to bottom-up security selection, seeking to avoid the individual companies most likely to crash and burn (i.e. idiosyncratic risk.)
Third, sound financial-sector analysis has become increasingly indispensable. For one thing, the opportunity set has been changing as rating downgrades have sent more securities into high-yield space. But also, for the euro high-yield market as a whole, it’s a fair assumption that the biggest driver of performance this year is going to be the financial sector—especially in the heavily-indebted peripheral countries like Spain. Financials now make up about 20% of the Barclays Euro High Yield index, with half of that in peripherals.
Fourth, we think that the risks of passive investing have increased. The high-diversification approach used by a number of investment managers—buying the broad high-yield index—is now riskier because of the risk of peripheral-driven volatility. We believe that active credit selection is potentially a better way to generate returns and control risk, although there are now more macro strings attached than there were in the past.
Assuming investors pay sufficient attention to the macro factors and engage in active security selection, we think there are plenty of opportunities in euro high yield. Potential returns are compelling, with the average option-adjusted spread of the Barclays Euro High Yield index currently around 6.5%, amounting to a total yield of about 8.5%. In our view, this type of yield can be obtained, at lower risk levels, by avoiding a number of risk clusters in the index while still maintaining a high degree of diversification.
Attractive Opportunities in Euro High Yield
The key is to take only the risks that you’re confident that you’re paid to take, and to make sure that you are truly diversified. For example, at the moment we don’t find the lowest-rated (CCC-rated) bonds compelling. CCC-rated debt can boost portfolio performance in the early stages of a market upturn, but given the uncertainties in today’s environment we don’t believe that the yields are high enough to justify the risk exposure.
We don’t believe that there are any safe generalizations to be made at the sector level, and we recommend case-by-case analysis of individual names. We see selected examples of value across the spectrum, from economically sensitive sectors like basic materials to counter-cyclical sectors like pharmaceuticals.
Although we think financials will be a potential driver of volatility of high-yield returns in the coming year, we’re not suggesting that investors should shun the sector altogether. It’s true that, in some cases, the expected returns may be outweighed by both systemic and idiosyncratic risks. For example, we might have a negative outlook on both a financial institution and the country in which it is domiciled. But in many cases, levels of country and idiosyncratic risk may be acceptable. In our view, examples include subordinated debt issued by some of the stronger UK banks. Spreads on their bonds have widened in recent months, along with the rest of their sector, resulting in some interesting valuations.
In summary, high-yield investors in 2012 will need to get their macro analysis right as well as their company research, and they should be mindful of the risks of broad index investing. But, for active credit managers who are able to adapt to the challenges and extract value from undervalued securities, we believe that the coming year will bring significant rewards.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.