by It’s not an easy time to be a fixed-income investor, particularly for those seeking opportunities in the United States. The Federal Reserve’s stated intention to raise benchmark interest rates this year for the first time since 2006 hangs over the U.S. fixed-income market like a pall, threatening to drive bond prices down, introduce volatility, and even create a liquidity crunch. Investors who want (or need) to maintain exposure to fixed income through the rate hike might try looking across the Atlantic Ocean. Credit Suisse expects European high-yield bonds to be a better investment than their U.S. counterparts over the next few months for a variety of reasons. The first: A lower risk of default. The credit rating agency Moody’s expects the default rate on European high-yield bonds to fall from 2.32 percent in April 2015 to 2.1 percent in June 2016, while the U.S. rate is expected to increase from 1.72 percent to 2.88 percent over the same time period. While those forecasts may seem counterintuitive, given the relatively early state of Europe’s economic recovery and the brinksmanship investors witnessed earlier this summer over Greece’s debt negotiations, the spoiler in the U.S. high-yield market is the U.S. energy sector, which poses a particular threat to yield-seeking investors. Oil and gas companies make up 15 percent of the U.S.
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Ashley Kindergan considers the following as important: Europe, European credit, Federal Reserve, high-yield, Interest rates, Investing: Features, oil and gas
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It’s not an easy time to be a fixed-income investor, particularly for those seeking opportunities in the United States. The Federal Reserve’s stated intention to raise benchmark interest rates this year for the first time since 2006 hangs over the U.S. fixed-income market like a pall, threatening to drive bond prices down, introduce volatility, and even create a liquidity crunch. Investors who want (or need) to maintain exposure to fixed income through the rate hike might try looking across the Atlantic Ocean.
Credit Suisse expects European high-yield bonds to be a better investment than their U.S. counterparts over the next few months for a variety of reasons. The first: A lower risk of default. The credit rating agency Moody’s expects the default rate on European high-yield bonds to fall from 2.32 percent in April 2015 to 2.1 percent in June 2016, while the U.S. rate is expected to increase from 1.72 percent to 2.88 percent over the same time period. While those forecasts may seem counterintuitive, given the relatively early state of Europe’s economic recovery and the brinksmanship investors witnessed earlier this summer over Greece’s debt negotiations, the spoiler in the U.S. high-yield market is the U.S. energy sector, which poses a particular threat to yield-seeking investors.
Oil and gas companies make up 15 percent of the U.S. high yield market, while their contribution to European high-yield markets is small, according to Nathalie Dantes, a senior credit research analyst in Credit Suisse’s Private Banking & Wealth Management Division. At $43 a barrel, West Texas Intermediate oil, which is produced in the United States, is trading close to a 52-week low. With the steep decline in oil prices that began last summer showing no sign of a sustained reversal, highly leveraged energy companies that borrowed at the height of the shale boom are running ever-increasing risks of default.
It’s not that Europe isn’t without its concerns; current credit spreads for European corporate indicate a much higher risk of default than their historical norm. European bonds with BB or B ratings currently have implied default rates of around 12 percent and 23 percent, respectively, compared to long-term default rates of 4 percent and 13 percent. But the reality is European corporate debt appears to be getting less risky, not more so. European companies have been taking advantage of the low interest rates that quantitative easing has ushered in to refinance existing debt, even as new issuance has been relatively subdued.
A relatively favorable interest rate outlook provides another reason to favor European credits over American ones. While the potential for rate hikes has already sent U.S. corporate and Treasury yields higher – yields on one high-yield index have risen from 6.67 percent at the beginning of July to 7.19 percent as of mid-August – quantitative easing should keep bond yields relatively low, and prices relatively high, in Europe.
The caveats: The European high-yield market is smaller and less liquid than its U.S. counterpart, and the Federal Reserve’s move could introduce volatility into fixed-income markets around the world. As capital requirements have pushed banks in both Europe and the U.S. out of the market-making business, fixed-income markets are considerably less liquid now than they were beforethe financial crisis. Some market observers fear a liquidity crunch in the event of a sudden selloff. But even so, high-yield investors are better insulated from rising rates than those in investment-grade bonds, which have longer durations and lower coupons.
Credit Suisse recommends choosing select non-financial issuers in European high-yield and steering toward BB-rated bonds over those with B, CCC, or C ratings. Such an allocation provides investors with higher yields than they would receive from either sovereign or investment-grade corporate bonds in Europe, with less default risk than high-yield bonds from U.S. or lower-rated European issuers. The strategy also offers relatively good protection from rising rates. In other words, it’s not so much chasing yield as playing defense.