Investors, dismayed with the miserly returns on offer from risk-free assets such as government bonds, sought higher-yielding asset classes, with sub-investment grade bonds benefiting accordingly. Despite this headline strength, ongoing issues in the eurozone have caused the market to be volatile. After a strong start to the year, the outcome of the Italian general election in February unnerved markets with a "no to austerity" protest vote.
This cast renewed doubt on whether Europe’s governments were capable of implementing the necessary measures to salvage the financial system, resulting in a short-term sell-off in risk positions.
The market recovered its equilibrium in March. Positive US economic data outweighed the negative influence of events in the periphery, where troubles in Cyprus had fallen under the spotlight.
The rally continued through April, with May marking the 12th consecutive month of positive returns for European high yield and the third-longest run on record.
In early summer, the market suffered another correction when Ben Bernanke, chairman of the US Federal Reserve, began to talk of a tapering of the rate of emergency monetary accommodation that the Fed was providing to the financial system, as a result of better US economic data.
Markets were unnerved, fearing that any such move was a precursor to a hike in US interest rates. Accordingly, riskier asset classes such as high yield sold off.
Prices were driven sharply lower, with yields in European high yield rising to roughly 6.25 per cent. But was this justified? After all, high yield is not traditionally recognised as an interest-rate sensitive asset class.
While all asset classes displayed volatility, this was a rates-induced sell-off rather than a risk-asset sell-off, and longer duration, lower-coupon bonds suffered the most.
In this context, high yield fared relatively well compared with the more interest-rate sensitive segments of fixed income (government bonds and investment grade credit).
From the start of May to the middle of August, the yield on the 10-year gilt rose 112 basis points from 1.62 per cent to 2.74 per cent, producing a negative return of 8.4 per cent, while sterling investment grade corporate bonds fell 0.81 per cent.
This compares with a positive return from European high yield of 0.55 per cent over the same period.
Furthermore, we should remind ourselves that in the face of all the market noise, we had not seen a change in the credit environment for high yield companies.
In our opinion, the economic environment in which they operate remains pretty benign. For the most part, they still enjoy a fair degree of liquidity, and few are particularly pressured in terms of upcoming maturity schedules.
Accordingly, we considered that there was little fundamental justification for June’s fall in high yield prices, so we used the market movement to add to positions at what we considered to be attractive levels.
Subsequent events proved us correct, with the market rallying 2 per cent in July, taking the yield to 5.5 per cent.
The market bounce in July allowed the window for supply to open, and more than a dozen new deals were priced.
However, the quality of some of these deals was less than compelling: a number of relatively small companies came to the market with little in the way of operating momentum.
Smaller high yield deals offer lower liquidity and have a higher propensity to default, so they must offer sufficient premium, and/or have a strong credit story.
One of the new issues of interest to us was Marlin, a specialist UK purchaser of defaulted debt. It has a strong operating story in an attractive and growing sector. Elsewhere, Schaeffler – a German-headquartered industrial giant – launched a payment in kind/toggle deal that was well received.
More recently, dovish rhetoric from the Federal Reserve and the European Central Bank (ECB) has helped markets stabilise further.
Ben Bernanke has been at pains to emphasise that the tapering discussion is only the start of the removal of stimulus from the market and is separate to raising interest rates.
Meanwhile, ECB president Mario Draghi has commented that he expects interest rates to remain at present or lower levels, although he did not pre-commit to a certain rate path.
Following the press fanfare ahead of Mark Carney’s arrival as the new Bank of England governor, his implementation of forward-rate guidance policy aimed at allaying market concerns of imminent rate rises in the UK did not have the desired reaction, with gilt levels rising.
Despite this, we still think UK interest rates will stay low for some time, with gilt levels remaining contained.
In this context of continued low risk-free rates and a benign operating environment for companies, we view European high yield, with its short duration, low default rate and satisfactory corporate earnings outlook, as an acceptable place in which to allocate.
A note of caution, however: this paradigm will not persist indefinitely as credit fundamentals will eventually deteriorate and the cycle will turn.
Meanwhile, the market looks likely to remain range-bound, with frequent bouts of volatility which will present opportunities for high yield investors.
Lesley O’Neil is fixed income director at SWIP and manager of the SWIP European High Yield Bond fund.
The fund has returned 25.3 per cent since launch in December 2011, compared with a return of 22.99 per cent for the average fund in the sector.
Performance of fund vs sector since Dec 2011
Source: FE Analytics
