European High Yield to weather volatility

What are the factors that may favour the high-yield sector? 

The European High Yield index is currently yielding 7%, which is almost double the yield investors received from the asset class a year ago. This creates an attractive entry point for investors looking for income and total return, particularly given spreads for the European High Yield index remain in the third quartile relative to history. The macroeconomic environment in Europe has also improved following the recent drop in gas prices and the reopening of the Chinese economy, which should alleviate some of the inflationary concerns in the region. With that said, we expect the European Central Bank to continue its tightening path, which will have implications for growth. Fundamentals for high yield issuers remain solid, but we will likely see some weakening in next 6-12 months as lagged policy effects work their way through the economy. However, we do not expect the default rate in European high yield to rise to past recessionary levels.  

Recently you have argued that the sector could still be volatility, how do you hedge against this?

In this type of environment deep, bottom-up fundamental research is critical to identifying the issuers with sustainable competitive advantages to weather the heightened volatility. To do this, I work with a large team of analysts to understand each company’s business model and determine whether the company will be able to sustain cash flows in the future. Specifically, we use the Morningstar’s Moat framework as a key tool to determine whether a company has a sustainable competitive advantage or “moat”. Some examples include: a cost advantage that is hard to replicate or benefiting from high-quality intangible assets such as a brand or patent. 

We view ESG as an alpha driver, and so we incorporate ESG considerations into our investment process and engage with companies that exhibit weaker ESG practices. Specifically, we tend to focus on company management and the overall culture of the company as we believe these directly impact their ability to generate sustainable cash flows. We also look to avoid sectors or geographies that are increasing in capacity as we believe these areas will experience higher default rates if market volatility persists or the cycle turns. 

Do you think the default rate could increase during the course of the year?

While default rates are likely to move towards long-term averages over the next 12 months, we do not expect a full-scale default cycle. In Europe, default rates remain at historical lows, partly because the overall European high-yield market is higher quality relative to history. Today, approximately 70% of the companies in the Euro High Yield universe are BB-rated, compared to the US in which 50% of the companies are BB-rated.

Attractive opportunities on High Yield 

We continue to identify interesting opportunities in the packaging sector, specifically food packaging and glass packaging companies which benefit from high switching costs. This sector has also been disproportionately impacted by the threat of Russian gas being turned off. I saw this as an opportunity to add to high quality companies at very attractive price levels. We also favour companies in the health care sector, mainly those involved in various health care services, and the technology sector, mainly new technology companies that serve as payment systems or provide information to banks on various credit ratings.