Outlooks split on where high yield will sparkle next

Global high-yield markets have rallied following a difficult few months, but money management executives are divided over the outlook for the U.S. and European markets and where best to place their bets.

Europe is drawing renewed interest, thanks to unprecedented monetary policy, including a move further into negative territory and an extended and expanded asset purchase program. Concern over default rates and commodities exposure in the U.S. also is heightening Europe's appeal, managers said.

But both the U.S. and Europe look attractive right now. Investor sentiment on commodities, interest rates and other external factors will help to determine specific exposures.

“There is far more interest, and we are certainly seeing interest in the high-yielding sectors of the debt markets,” said Paul Cavalier, partner and head of Mercer LLC's bond boutique in London. “That is generally consistent with this hunt for yield, a move away from risk-free assets that are delivering poor expected returns going forward.”

Return expectations for U.S. high yield are about 7.7% for 2016, and for Europe, 4.5%, sources said. That compares with -4.6% and -9.5% in dollar terms, respectively, in 2015, show the BofA Merrill Lynch U.S. High Yield index and the BofA Merrill Lynch Euro High Yield index.

Defaults are expected to hover around 1% in Europe, but could move north of 5% in the U.S., due to its significant exposure to commodities.

“We continue to see a lot of interest in the asset class — I think even more out of Europe than the U.S., both for European high yield and U.S. dollar,” said Rob Cook, managing director and global head of high yield at J.P. Morgan Asset Management, based in Indianapolis. Appetite from Europe is down to “perhaps having a little more yield-starved environment.” J.P. Morgan Asset Management runs $57.9 billion in global high-yield strategies.

But while higher returns are forecast for the U.S., some executives warned that the country is in for a bumpier ride than Europe.

“At this point, the main difference is in the investor's outlook on commodity prices and the follow-through effect on (the) U.S. high-yield default rate in the energy and metals/mining space,” said John Yovanovic, head of portfolio management, high yield, at PineBridge Investments in Houston. “If commodity prices retrace lower, Europe will outperform; if they continue the current trend of moving higher, the U.S. may outperform. We anticipate similar returns on a constant currency basis.”

Andy Burgess, London-based fixed-income portfolio specialist at Insight Investment, said that while the U.S. high-yield market appears to offer higher spreads than its European counterpart, much of this dispersion comes down to different characteristics of the underlying markets.

“Over 60% of the European high yield market is BB rated, compared to only 49% in U.S. dollars,” Mr. Burgess said. With more than 20% of the U.S. market exposure to commodity-sensitive sectors, “the risk of a correction remains.”

Wider macro events are helping investors to determine their positions and preferences.

European high yield received a “shot in the arm” in March when Mario Draghi, president of the European Central Bank, announced an extension to the ECB's asset purchase program, said Olivier Monnoyeur, lead portfolio manager, high yield, at BNP Paribas Investment Partners in London.

“Two or three weeks after (the announcement), Europe has outperformed, but now it seems we are back to oil, gas and metals driving the sentiment again, which puts U.S. high yield in a slightly better situation,” Mr. Monnoyeur said. “The commodities sector is much bigger in the U.S.; in March we saw renewed outperformance of the U.S. vs. Europe.”

BNP Paribas runs e3.1 billion ($3.5 billion) in high yield.

Neutralized sentiment in China after “being extremely bearish last year (is) adding to the supportive backdrop for credit generally,” in both Europe and the U.S., Mr. Yovanovic added.

An added boost to the asset class is that it is comparably favorable to other options in the markets.

Following the ECB's announcement, investment-grade bond spreads tightened overnight, constraining yields available in an area of the markets in which institutional investors typically play, said Martin Horne, head of European high yield at Babson Capital Management LLC, based in London. Investment-grade players that had centered their investment on corporate bonds reached “down into the higher end of the BB universe.” The firm runs $10.8 billion in global high-yield bonds.

“Europe really has seen huge inflows continue, something like 5% of assets under management flow over the last three weeks,” said Marc Kemp, London-based institutional portfolio manager at BlueBay Asset Management LLP, which runs $10 billion in its global leveraged finance business that includes high-yield long-only strategies. “That really is a function of investment-grade bonds, courtesy of the ECB, getting to crazy tight levels — where do you get good yields from?”

European high yield is also well supported from a technical perspective, Mr. Kemp said. “We had negative net new issuance in Q1 2016. Couple that with strong inflows and no new product to feed the market, and it is unsurprising that returns have been pretty impressive the last few weeks.”

This positive sentiment, performance and backdrop to high yield have caused a “lot of soul-searching and analyzing of our thoughts on a daily basis” at BlueBay, Mr. Kemp added, because the money manager remains cautious on the asset class.

From a corporate earnings perspective, “stagnation” is probably the best outlook in the U.S., but there has been continued growth in Europe, irrespective of the ECB's actions, added Mr. Kemp.

But money managers are split. Andrew Jessop, high-yield portfolio manager at Pacific Investment Management Co., Newport Beach, Calif., said the firm favors U.S. corporate high yield vs. European, “given the higher yields, better growth prospects for the economy and its more diverse and liquid market.” Year-to-date U.S. high yield has outperformed European, partly explained by the underperforming banking sector being the largest sector in the European high-yield market; and the rally in the price of oil giving the energy sector — which has a larger weighting in U.S. high yield - a boost. “Going forward given the stronger fundamentals and higher yields in the U.S., we expect U.S. high yield to outperform over the cyclical horizon,” said Mr. Jessop.

For others, the U.S.' commodities exposure is making some managers cautious.

“(It) is really more a function of commodities, and a demand/supply imbalance in the resources sector in the States, which is making us feel very nervous,” Mr. Kemp said. “While we acknowledge some movement in the oil industry, we continue to have caution around the rest of the resources sector.”

BNP Paribas Investment Partners' Mr. Monnoyeur said executives have a “slight preference for Europe right now, because we are not particularly keen on the commodities sector,” and that despite current comfort around commodities, oil and metals in the markets, “we think this is not really sustainable.”

Europe's consumer focus is more attractive, as well as other sectors “that are not going to be as commodity-dependent as the U.S.”

Sandro Naef, Copenhagen-based co-founder of Capital Four Management, said while Europe is less vulnerable to interest rate shocks, some investors are “somewhat complacent about interest rate risk.”

Babson's Mr. Horne agreed that “people don't talk about interest rate risk in Europe enough. It is there, just more subtle than in the U.S.” He said he is cautious around some of the longer-duration bonds in Europe.

Another issue for Europe is the upcoming referendum on the U.K.'s future membership in the European Union.

“We think the U.K. will do fine without Europe — certainly over the medium- to long-term — but it may be negative for the European high-yield market if the U.K. were to leave,” with weakness driven by the spreading of disintegration forces, Mr. Naef warned. “That, maybe, we shouldn't underestimate.”

But Mr. Monnoyeur said there are also credit-picking opportunities from the so-called Brexit.

“In Europe, we are trying to find ideas that either we think are showing some stability ... or suffering some selling pressure. (One example is) sterling bonds — as everyone is getting excited, or scared, about Brexit.”

The firm started to sell sterling bonds early this year, and now is buying back the same or different bonds with a “focus on companies with pure U.K. operations, where they will not be affected on a fundamental basis by whatever (any) Brexit means for them,” Mr. Monnoyeur said.