Jack Holmes, High Yield Fondsmanager at Artemis says that we cannot be sure what the next decade holds, “but history suggests this period of high inflation and interest rates is unlikely to be the same as the last. You may need to adjust”.
He points out that investors often ask global managers “like us whether we prefer European or US high-yield bonds. If only the answer were as simple as the question. Let’s start at the top – the yield difference between the two markets”.
Holmes details that over the past 10 years, as the blue line in Figure one shows, US high yield has consistently delivered more than the European high yield – typically between two and three percent, but on occasion much more.
“You might assume that income-focused investors should therefore concentrate on US assets. But it is more complicated than that. What about currency movements – often driven by interest rate differentials? Foreign exchange volatility is overwhelming relative to the volatility of bond prices. If you are not careful, you can spend more time second-guessing currencies than researching underlying securities”, says.
He adds that they prefer to hedge the currency risk in multi-currency bonds, “allowing us to focus on credit risk, which is where, in our opinion, a bond manager adds the most value. This makes the simple yield less relevant. What tends to be more significant, then, is the level of spread over that currency’s risk-free rate. The orange line in Figure one shows the same comparison – European versus US high yield – factoring this in. It demonstrates that investors still get more income by investing in US high yield, but it is not as much of a slam-dunk”.
Figure one: The difference between US and European high yield – the US yield typically offers greater yields, but when you compare the spread between the high yield rate and the risk-free rate in each region the difference is reduced
Source: Bloomberg as at January 2023.
Are we comparing like with like?
Holmes explains that “If you look at the aggregate numbers, European high yield and US high yield tend to have very different levels of credit risk. Figure two shows the average rating of each market over the past 10 years. As we can see, the European high-yield universe tends to be of significantly higher quality than the US high-yield universe. Comparing the two against each other is not really comparing apples to apples. The default risk is higher, on average, in the US, and we therefore would expect more compensation”.
Figure two: Over the past decade the European high yield universe has been of higher quality
Source: Bloomberg as at January 2023
“If we look in closer detail at each grade of credit – to help adjust for the difference in aggregate quality – we see the picture is even more confusing. Take a look at Figure three. USD BBs (the blue line) offer a better credit spread than Euro BBs (represented by the horizontal axis). This is common – perhaps because they tend to be longer duration, so riskier. On the other hand, US Bs (the orange line) usually offer less credit spread. Over the past 10 years, the spread pick-up in single-Bs between the two regions has often been quite significant. The only times US single-Bs have offered greater yields was 2015/2016 and 2017 – periods characterized by a large US high yield sell-off in energy bonds”, points out.
Figure three: US BBs tend to offer a better yield than Euro BBs, but US Bs generally offer less yield than their European equivalents
Source: Bloomberg as at January 2023.
So, it’s not that simple
The expert explains that this all shows that the comparison between Euro and USD high yield is not as simple as investors might like to think – and that the picture can change. “Even within individual businesses the story can be complex. Let’s look at two companies and one final chart. Coty is a global beauty products business; Cheplapharm is a European-headquartered pharmaceutical business. Both issue Euro and USD bonds. In figure four we compare the credit spread pick-up on both companies’ USD bonds over their Euro bonds. The bonds compared have the same maturity and place in the capital structure – so face identical credit risks. With Coty investors have enjoyed a healthy premium by opting for its Euro bonds – peaking at over 150bps last summer. With Cheplapharm the premium has been found investing in the company’s USD bonds. So, far from being a top-down opportunity, two individual credits are giving opposing cross-currency opportunities!”, says.
Figure four: Coty offers a premium for its Euro bonds; Cheplapharm for its USD bonds.
Source: Bloomberg as at January 2023
Conclusion
Finally, Holmes concludes that all of this – and years of experience – “leads us to conclude that a developed market global high yield bond manager delivers most alpha not from guessing currency moves or switching emphasis between the US and Europe from time to time, but from good analysis and being constantly alert to individual credit opportunities (and risks) in both arenas.
In conclusion, if you have the misfortune to meet a high yield bond manager, a better question to ask than whether US or European high yield is better would probably be: “Which companies and bonds do you like most?” The answer is likely to be mercifully shorter and a lot simpler!”.
