High yield investors sweat for return in European market

European high-yield bond investors are having to work harder in a busy primary market to preserve returns, as thin coupons and issuer-friendly structures become the new normal.
With borrowers enjoying one of the best markets in recent years to issue new debt, portfolio managers are having to adopt different strategies including increased exposure to higher-rated issuers, looking at US companies selling bonds in Europe or simply reducing their participation in new transactions.
“We are pleased that supply has picked up, but we have been disappointed by the quality and pricing of some of the new deals,” said Tom Ross, a high-yield portfolio manager at Janus Henderson Group in London, who recently reduced average participation in new issues being marketed in Europe to less than 25% from 50 to 70% traditionally. 
“Demand is currently still strong, however we are concerned it might drop given the performance of recent deals.”
European high-yield issuance this year is poised to set new records with volumes already totalling €64bn, equivalent ($75.4bn), close to the €66bn, equivalent record for the whole of 2015, according to data compiled by Bloomberg. 
The increase in supply comes as borrowers take advantage of a regime of low rates and low volatility amid strong demand from yield-hungry investors.
While the rush of deals is partly sating investors’ appetite for the asset class, transactions so far in 2017 are generally offering lower coupons and lighter covenants than in previous years. 
The average coupon on high-yield issues year-to-date has fallen to 4.4%, compared to 5.3% in 2016, Bloomberg data show.
“Valuations are tight, so we need to make sure we’re getting paid for the risks in the market,” said Vivek Bommi, a senior portfolio manager for global and European high-yield at Neuberger Berman, which has $123bn of fixed-income assets under management. 
“We’re being more selective in general. We may like a triple C name but if it’s coming at very tight levels, without much upside, we won’t hold.”
High valuations have also pushed fund managers to increase exposure to higher-rated credits, with Janus Henderson’s Ross saying the firm is looking to invest more in double B and rising star names, as well as less cyclical credits. Neuberger Berman’s Bommi said the fund is overweight double B versus single B and triple C given the narrow spread between these rating categories.
Overall covenant quality has been declining in European high-yield, with more than 37% of sub-investment grade euro-denominated bonds classified as weak or weakest in the first half of this year, up from around 12% in 2012, according to Lisa Gundy, a senior covenant officer at Moody’s.
“There has been degradation in covenant quality and disappointing term structures in the primary market,” says Mitch Reznick, the London-based co-head of credit at Hermes Investment Management, which oversees about $32bn in assets. “We’re also seeing a lot of deals with shorter non-call periods, in which investors won’t benefit from credit improvement over time,” given that any potential upside is capped earlier, he said.
Lower-quality credits may also be challenged by a potential slowdown in economic growth next year if interest rate increases, according to Reznick. The asset manager said it is looking across different jurisdictions for investment opportunities, including reverse-yankees or European issuers in the US.
A €735mn bond sale from Stada Arzneimittel’s in September was an example of this new dynamic, with the deal being upsized on the back of a strong order book despite investors’ attempt to push back on a covenant clause.
The high-profile of the company and sheer size of the deal – one of the largest buyout-related leveraged issues in Europe so far this year – may have encouraged investors who are under pressure to deploy cash to tolerate softer terms and take part in the sale, according to sources familiar with the transaction. In other recent deals such as Avantor and Diversey, investors lobbied successfully to remove issuer-friendly provisions.
Yet for some investors, returns in the European high-yield market are still attractive given razor-thin government bond yields, the positive economic backdrop in the region and low default rates. Yields on the Bloomberg Barclays Pan-European High Yield Index have tightened to 3.29% from 4.61% almost a year ago.
“Whilst skinny, risk premium offered by the market is positive,” said David Allen, chief investment officer at the European credit fund AlbaCore Capital, which has €500mn in assets. “With sovereign debt paying nothing in Germany, for example, it makes sense for investors to get excited about making four to 6% on something they think is safe.”

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