It is highly likely that lagging data will reveal that Europe is already in a recession at this point in time, which comes on the back of an abysmal year for investors.
However, for bond investors, even in the economically sensitive high yield segment, this revelation will not necessarily prove the terrible news that it may seem to be.
Indeed, combined with the year-to-date drop in bond prices, it could present an opportunity that we have not seen for a long time.
A quick recap: High yield has seen by far the worst calendar year of all time in 2022, with the exception of the financial crisis in 2008. Returns have been influenced predominately by significantly higher yields on government bonds as well as the impact of the war in Ukraine.
The latter has partly been reflected in the sharp rise in natural gas prices, especially in Europe, which due to the design of the market, has meant that electricity prices in Europe have also spiked higher, putting significant strains on many businesses.
Consequently, the broad European high yield index, ICE BofA European Currency High Yield Constrained Index (HPC0), has seen spreads balloon from 338 basis points (bps) as of end 2021 to around 550 bps today. Interestingly, however, unlike in normal years when returns were sharply negative, default rates have not meaningfully increased this time around and remain under 1.0%, well below long-term averages.
History suggests that any period of particularly poor performance in high yield has always represented a good time to invest, as returns following a negative year are often characterized by a substantial rebound. The asset class from a global perspective has actually never suffered two negative years in succession. In this context, the home region for European investors looks particularly promising compared to other geographies.
Of course, the asset class has been hit with significant outflows, which is quite typical of a negative year. Nevertheless, the path to this poor year has deviated significantly from what we typically see in in a recessionary environment, namely sharply higher spreads of around 800 bps in Europe and a significantly higher default rate. Neither is the case currently.
Although average bond prices are at quite low levels and reflective of a recession, current prices are much more a factor of low coupons in the issuance of recent years and interest rate hikes over the last few months than a reflection of higher spreads, as would typically be the case at this stage of the economic cycle. Currency considerations also point towards European high yield as a favourable segment, since US dollar hedging costs for euro or Swiss franc investors are also quite high, considerably diminishing the total returns available in US high yield bonds.
Regarding the timing of investments, we still think spreads could move somewhat wider, meaning there is no immediate rush. However, it makes sense to start thinking about the high yield asset class and to prepare to move when the time comes.
We believe the next 12 months will eventually provide solid returns for investors, although probably not in a straight line. Low bond prices, provide a valuable entry point for new investors and while painful for existing investors, low prices also provide an attractive opportunity to increase allocations, as they limit losses in the case of default. Prices in the 75 to 85 range on the dollar already reflect a sizeable drop and are much closer to potential recovery values than they were a year ago.
This built-in cushion compensates investors for the additional risk in a similar way that higher spreads would, which is why we believe spreads of 700 bps, somewhat higher than current levels, would provide an adequate risk premium. Normally, spreads rise to around 800 bps in a recessionary environment, but we do not expect default rates to reach normal recessionary levels as the proportion of the index with low-quality issuers is smaller than previous periods and issuers enter the downturn with better fundamentals, solid liquidity, and few covenant problems.
Importantly, spreads usually hit their peaks well before a recession ends. Hence, in order to invest anywhere near the spread peak levels, investors need to enter the market before the next upturn, i.e. when it’s darkest before the dawn. In addition, volatile times like these should be welcomed by active managers as they should provide ample opportunity to generate alpha.