by Neuberger Berman Fixed Income Investment Strategy Committee
You might be surprised to learn that European high yield bonds were the top-performing credit market over the 10-year period ended August 31. In all honesty, some of us were, too. The development of the asset class in the years following the financial crisis, however, is impossible to ignore. We think European high yield bonds have earned a place as part of an investor’s strategic allocation, offering an attractive diversification opportunity marked by high hedge-adjusted yields, relatively low duration and robust market fundamentals in an improving macro environment.
Surveying the tight valuations across the fixed income investment landscape, it’s hard to shake the feeling that the asset class is vulnerable. That said, it’s just as hard to pinpoint how and when that vulnerability may manifest itself given the durability of the current credit cycle. As we discussed in our 2Q17 Fixed Income Investment Outlook, the below-average economic recovery in the years following the Great Recession seemingly has suppressed the development of excesses across the economy and financial markets, extending the business and credit cycles. Meanwhile, interest rates globally remain anchored at very low levels even as the U.S. Federal Reserve continues along its cautious policy normalization path and the European Central Bank prepares to wind down its own stimulus efforts.
So the search for yield persists, as does the compression of spreads on assets able to deliver it. We continue to see strong flows from our clients into opportunistic, go-anywhere mandates across public and private fixed income markets, as well as into more targeted opportunities in areas like emerging markets debt and high yield. One source of yield that perhaps is less universally recognized is European high yield debt, despite a 10-year annualized return of 9.0% on a hedged U.S. dollar basis as of August 31, 2017, which ranks it number one among credit categories globally, as shown in Figure 1.
Figure 1. European High Yield Has Led Global Credit over the Past 10 Years
Annual hedged returns in U.S. dollars as of August 31, 2017
Source: Bank of America Merrill Lynch.
Note: U.S. HY = BofA ML U.S. High Yield Master II; EU HY = BofA ML European Currency High Yield; EM Debt = BofA ML EM Corporate Plus; U.S. IG = BofA ML U.S. Corporate Master; EU IG = BofA ML Pan Europe Large Cap Corp; Global HY = BofA ML Global High Yield; U.S. Loans = S&P/LSTA Leveraged Loans.
A Globalizing High Yield Market
For some time, exposure to high yield bonds meant, for all intents and purposes, exposure to U.S. high yield bonds, with non-investment grade offerings issued in other domiciles too small to play a role in the allocation decisions of most investors; in fact, as recently as 10 years ago U.S. high yield accounted for approximately 90% of the global high yield benchmark. Once exclusively the provenance of so-called “fallen angels” (i.e., bonds stripped of their investment grade ratings), the high yield market in the U.S. found its footing in the 1980s and subsequently has matured into a key strategic allocation for investors of all types, offering a compelling combination of risk, return and correlation benefits for the investor and financing flexibility for the issuer. Despite the runaway success in the U.S., however, high yield bonds were slow to catch on elsewhere, including in Europe, where corporate financing was dominated by banks and there was little to suggest the growth in issuance that would eventually emerge.