By Jorgen Kjaersgaard
The European financial crisis continues to challenge high-yield investors. Some were wary of Europe's issues and stepped away last year, only to see European bonds dominate through the unpredictability. Others want in now, but worry that they've missed the rally.
Does an allocation to Europe make sense? We think so -- there seems to be plenty of upside potential left in 2013.
The economic outlook is improving. Euroarea households and businesses are still cutting debt, hurting growth. But the European Central Bank should continue to stabilize the economy and provide liquidity to banks if needed. We think the economy will start to stabilize during the first half of this year. We don't expect much growth, but that won't necessarily hold bond markets back. Growth was flat in 2012, but European investment-grade and high-yield bonds posted very strong absolute returns (though from much higher yield spreads than we see now).
We expect global growth of about 2.5% in 2013. This should support global trade and credit markets generally. With low inflation in developed economies, central bank rates and government bond yields shouldn't change much. But look for yield spreads on credit to remain volatile until Europe addresses many of its underlying problems.
Europe's credit market -- high yield in particular -- has grown rapidly. In the four years ending in 2012, the Barclays Pan-European High Yield Index grew from less than €40 billion to more than €240 billion, and issues more than doubled. The market's character has also changed, largely due to the euroarea crisis. "Fallen angels" increased (see below) -- these are primarily financial companies whose bonds were downgraded from investment-grade ratings and entered the high-yield market.(click to enlarge)
Growth has also come from companies switching from bank loans to bond issuance as they were able to secure financing at low absolute interest rates, and from companies domiciled in the peripheral European markets that saw their valuations hit.
Defaults and downgrades could increase. Although we see a lot of opportunity, investing won't necessarily be a walk in the park. Last year's momentum-driven investment flows tended to favor larger issuers, which performed well even when fundamentals were flawed. The market should be more discriminating in 2013. We also see signs that overall credit quality is deteriorating. This, coupled with low growth, could increase defaults vs. 2012, when there weren't many defaults -- or downgrades -- with the exception of financials. Still, a dose of perspective is important: defaults have been extremely low by historical standards.
Investors will need to be selective. We also see more dispersion ahead among individual issuer returns in high yield than there was before. What investors don't own will matter as much as what they do own -- and research is critical in making these decisions.
Here are a few examples. Some financial companies -- especially "fallen angels" -- seem compelling. Overall we’re staying away from debt-heavy companies, many of them cyclical, that don’t offer much yield. Seventy percent of issuers in the high yield index are rated BB, and many of these are very large issuers that face future refinancing headwinds if markets become more risk-averse again. Selectivity is the watchword: Issuers that can withstand economic contraction and stay on a stable or improving credit path should be emphasized.
Our overall assessment? European high yield still offers attractive opportunities and a yield advantage, even if European markets still face challenges; difficult policy decisions could hurt confidence and increase volatility. The true danger is systemic risk -- a negative event that impacts the entire market, investors' behavior and the economy. But in a generally supportive environment for European credit, we think the positives outweigh the negatives.
Jorgen Kjaersgaard is a Portfolio Manager of European Credit at AllianceBernstein.
Disclosure: 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. Past performance of the asset classes discussed in this article does not guarantee future results.