European high yield: Raised energy prices create opportunities

In recent weeks, surging natural gas prices across Europe have raised concerns about inflation, negative impacts on consumer spending and overall corporate profitability. The rise in prices has been breath-taking, with natural gas soaring from €20 per megawatt hour at the start of May to €138 per megawatt hour in October1. However, we do not believe that these price increases portend a coming default cycle in the European high-yield market. In fact, we believe that the recent spread widening, which has taken spreads to around 100 basis points (bps) wider than the recent tights in 20172, has created an attractive buying opportunity for investors looking for both income and total return.

While inflation has now reached 3.4%3 in the eurozone, and we believe it could go higher in the short term, it remains unclear how persistent inflation will be in the longer term. Even if this inflation risk were to materialise and be accompanied by higher interest rates, we would note that high yield has historically been largely insulated from movements in rates, as Figure 1 shows. By contrast, rate movements are a much bigger factor in the performance of higher-quality investment-grade corporate and government bonds.

In the table, we calculate the years of income required to offset a 25 bps increase in core rates between European investment-grade and European high-yield indices. Compared with investment grade, high yield offers a 2.4% yield pick-up, while also being 1.75 years shorter in duration. Assuming constant spreads, an investor in European investment grade would require more than three years of income to break even from the principal loss caused by a 25 bps rate increase, whereas an investor in European high yield would need a little under four months. This highlights that European high yield’s combination of shorter duration and higher coupon income can be highly beneficial in insulating investors from upward movements in core rates.

FIGURE 1

While rising energy costs and lower consumer spending can impact both top-line and bottom-line growth for corporates, many high-yield issuers today are starting from a position of strength in their overall balance sheets and liquidity positions. Even though earnings growth is likely to slow in the second half of 2021, we still believe growth will be positive.

Furthermore, a key philosophical tenet of our fundamental research is to look for companies that have “moats”, or sustainable competitive advantages. If inflation should prove more persistent, we believe this focus would help us in identifying companies and sectors that can better withstand inflationary pressures on their business models and margins. For example, the industries that we favour in the portfolio — such as services, technology and telecommunications — typically have the ability to pass through price increases. Of course, this generally means higher prices for the end consumer. Yet we believe that the combination of rising wages and the increased savings buffer consumers have built (amounting to 7% of incomes in 2020 alone4) will limit the overall impact on consumer spending.

Conclusion

In our view, the recent spread widening in European high yield has created a buying opportunity for investors looking for income and total return. This view is based on our belief that the outlook for defaults remains benign, consumers are in a strong position and the European high-yield market should be largely insulated from upward movements in interest rates. As always, we believe credit selection remains paramount in the European high-yield market, and we will continue to emphasise our “moats” framework in identifying attractive investment opportunities on behalf of our clients.

¹ Source: Bloomberg as at 6 October 2021 | ² The option-adjusted spread (OAS) of the ICE BofA Euro High Yield Constrained Index reached 234 bps on 25 October 2017 and was at 331 bps on 12 October 2021. | ³ Source: Bloomberg as at 30 September 2021 | ⁴ Source: Eurostat

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