Over late-June and early-July, European high yield underwent a rapid spread widening, undoing the gains experienced over the first trimester.
With the Greece crisis seemingly resolved (or kicked down the road), much of the weakness should be reversed as the search for yield gradually resumes, underpinned by ECB’s QE. The macro conditions are also likely to support credit as the cyclical recovery is set to continue over the next few quarters.
However, in Europe we have our reservations regarding the sustainability of growth, and we thus prefer the higher rated names (i.e. BBs). This bucket should also be better positioned in the event that China becomes a bigger worry over the next months and investors come to realise that global growth will remain sluggish for some time.
Our preference for EUR BBs over lower rated names is also justified by the relative value that they offer. First, YTD, Bs outperformed and their spread relative to BBs normalised from the exaggerated levels reached in late-2014. While history suggests that further compression could take place between Bs and BBs, we do not think the current macro outlook will be supportive in this sense.
Secondly, BBs spreads have lately become more attractive when compared to BBBs which could result in them benefiting from a yield scarce environment. Naturally, this assumption rests on our thesis that that Euro area yields will trend downwards over H2.
Thirdly, a lower premium for peripheral governments (Italy and Spain in particular) could spill into lower spreads for Spanish and Italian corporates and these are better represented in the BB index than in the B index.
Finally, the EUR BB-rated bucket is less exposed to cyclical sectors when compared to Bs; this, together with the stronger credit metrics should allow them to better withstand what we expect to be a long period of subdued growth. We also note that 15% of the EUR B-rated universe is made up of automotive issuers which have been benefiting lately from the cyclical European recovery but remain sensitive to the longer unemployment outlook and the adverse economic backdrop in Asia and Russia.
Meanwhile, the implications of an interest rate hike in the US are markedly different for HY and IG issuers, with HY names likely to outperform as the monetary policy starts normalizing. Indeed, HY spreads should tighten to reflect the lower credit risk that comes with a strengthening economy. There could be an opposite reaction in the event that the interest hike is perceived as premature and negative for the growth outlook. Indeed, if China fails to arrest the recent volatility in its equity markets and global growth risks rise as a consequence, we expect the Fed to delay the monetary policy tightening as needed.
We think that H2 could be, again, a tale of two halves for US high yield with some pressure possible over the first part if China triggers a resurrection of global growth worries. However, under such a scenario, weakness should be stronger for commodity-related names and be offset to some degree by lower US Treasury yields (given the prospect of a delay in rate hike towards December 2015 or early 2016). Eventually, we expect the Chinese authorities to announce novel solutions for preventing a credit crunch, most likely a combination of fiscal and targeted-lending which will support growth (albeit not a rebound). Hence, late in 2015 spreads are likely to tighten and the short end of the US Treasury yield curve will shift upwards.
This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri & Co. Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.