Are investors comparing ‘like with like’ when they compare US and European yields in credit markets?
At the beginning of the year, the European high yield bond market, represented by the Bank of America Merrill Lynch European Currency High Yield Index, was yielding 3.5 per cent. The US market, represented by the BofA ML US High Yield Master II Index, was yielding 6.2 per cent. Emerging markets corporate bonds, represented by the BofA ML Emerging Markets Corporate Plus Index, were yielding 4.5 per cent.
Which of these three markets had generated the highest hedged returns by the end of August?
Kudos to those who guessed that it was European high yield, with 6.8 per cent. Emerging markets corporates returned 6.2 per cent and US high yield 6.1 per cent.
Even more kudos to those who know that tightening credit spreads were not the primary reason for Europe’s outperformance. Spreads have tightened — but not enough to cover the 270 basis points that stood between European and US yields in January. To understand what really happened, focus on the key word in the question: “hedged”.
A Distorted View
With almost 300 extra basis points up for grabs, why wouldn’t a European investor shun domestic high yield for US high yield?
The answer is that buying bonds denominated in US dollars creates a foreign currency exposure which most investors will hedge using the forwards market, and that this incurs a cost, equal to the difference between the interest rates for dollars and euros at the point on the curve at which the forward contract expires.
Right now, with the European Central Bank (ECB) holding at negative rates and the Federal Reserve nearly two years into its rate-hike cycle, that difference is some 50 basis points for a three-month EURUSD forward, or more than 200 basis points annualised. A full currency hedge would therefore have wiped out a substantial part of the 270-basis-point yield advantage that US bonds appeared to promise at the start of the year. The flip side, of course, is that a hedged US investor buying European high yield bonds has been gaining 190 basis points, annualised, making up for most of the apparently lower yield on the bonds.
In other words, the yield differential observed at the top of this page was largely accounted for by the difference between the Euro and dollar risk-free rates, which was also the determinant of the cost of (or gain from) currency hedging.
What do we learn from this?
First, to be alive to the advantage of diversifying our high yield portfolio regionally — a wider universe of opportunity is especially useful in our search for returns when valuations are stretched everywhere.
And second, while interest rate differentials are so wide and credit spreads are so tight, to take extra care not to allow the economics of currency hedging to distort our view of the regional relative-value situation.
Don’t Miss Out
We have long advocated diversifying into European high yield bonds, and indeed loans. For 10 years, European high yield has been the standout performer in global credit. In that time it has grown to 20 per cent of the global high yield market, primarily due to a combination of investment-grade issuers being downgraded to BB in the aftermath of the financial crisis, and more companies seeking to diversify their borrowing away from bank loans.
As a result, 70 per cent of issuers in the European Currency Index are rated BB, compared with around 46 per cent in the US Index. As well as higher credit quality, European high yield generally exhibits shorter duration and a markedly different sector profile: It is much more exposed to banking and the auto sector, for example, while the US index carries much more energy and health care. This led to substantial divergence in performance during the oil price collapse of 2014-15, for example.
It is easy to assume that European issuers’ high quality, against an increasingly robust economic backdrop, accounts for the apparently lower yields on offer there. But, whenever you compare two regional credit markets, remember to factor in the differentials in risk-free rates and the consequent costs of currency hedging. Otherwise you could miss out, not only on a potential diversification benefit, but on the high yield sector’s best returns.
— Vivek Bommi, Senior Portfolio Manager — Non-Investment Grade Fixed Income, Neuberger Berman