European bond markets have been volatile in recent months, with high-yield financials suffering some of the worst turbulence. But we’ve seen this kind of volatility before, notably in 2008/2009. That bloodbath was followed by a highly lucrative rally.
Volatility can sow the seeds of opportunity. Careful research can unearth attractive opportunities in the medium and long term.
A Market Too Big to Ignore
High-yield financials have become increasingly hard to ignore, growing from less than 3% of the Barclays Pan-Euro High Yield index in 2002 to more than 20% today. Currently, a high proportion of banks and insurers across Europe—many of them high-quality names, in our view—are straddling the ratings divide, with their senior bonds rated investment-grade, but many of their subordinated bonds rated BB+ or lower.
Anxiety about the sector has depressed bank and insurance company bond valuations relative to nonfinancials. By the end of June the average yield to maturity for high-yield industrials was about 8.0%, while financials were yielding an average of 13.5% (Barclays Capital Pan-European High Yield index).
Compared with senior bondholders, holders of subordinated bonds stand to recover less of their money in the event of a bankruptcy, and (depending on the category of debt they hold) they may be the first to see their coupon payments suspended if the issuer can’t cover its interest costs. The three main categories, in order of riskiness, are: Lower Tier 2 (most protected); Upper Tier 2 (less protected) and Tier 1 (least protected).
The first big driver of growth in the high-yield financial sector was the credit crisis, which saw a slew of bonds downgraded to junk. Between August 2008 and May 2009, the number of issues in the index skyrocketed from 25 to more than 140 (see chart below.) Performance since then has been very strong: Since the end of April 2009, the index has generated annualized total return of around 35% a year (hedged into euros.)
Now we are seeing a second wave of entrants into high-yield space. Our banking analyst Steve Hussey estimates that, worldwide, Moody’s is likely to downgrade 57% of the Tier 1 issues in the Barclays Capital Global Aggregate index, 49% of Upper Tier 2 and 30% of Lower Tier 2. And he thinks the trend is likely to be more pronounced in Europe given the continuing debt crisis, as well as the fact that subordinated financials represent a bigger slice of the European index than they do of the US or global indices.
So, how do we see the risks and the opportunities?
In absolute yield terms, high-yield financials are offering a big pickup relative to industrials. They are also yieldy relative to senior debt. At the end of June, senior financials were offering an option-adjusted spread of about 2.9% over comparable government bonds, while investment-grade lower Tier 2 bank bonds offered about 4.8% (Barclays Capital Euro-Aggregate Corporate Index.) In the Pan-Euro High-Yield index, Ba/BB (the highest-rated) financials offered an average OAS of 7.3%.
If a bank or insurer looks attractive, moving down its capital structure into subordinated debt gives an investor exposure to the same issuer, with less protection than the senior debt, but with a healthy yield pickup to compensate for that risk. At the moment, we believe we are seeing numerous examples of good-quality banks that have subordinated high-yield bonds trading at very attractive yields.
On the risk side, issuer-specific research is as important as ever to separate out the value opportunities from the names that are cheap for a reason. But today it’s more important than ever to build country risk into bond valuations. This is particularly true for financials, which tend to be more closely correlated with government bond performance than industrials. And about half the financials in the index come from troubled peripheral countries like Spain, Portugal and Ireland.
In conclusion, we believe that, in the longer run, euro high-yield financials are an opportunity that investors can’t afford to ignore. The market has grown and, when volatility levels settle, we think valuations are likely to be compelling. The keys to success will be rigorous research at both the micro and macro levels, and careful monitoring of risk.
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.