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Phil Milburn and Claire McGuckin, co-managers of the GBP1.7bn Kames High Yield Bond Fund, have been taking profits from European positions and increasing the portfolio’s weighting to US debt over valuation considerations and fears over covenant degradation on the continent.
The managers, who have returned 5.24 per cent year-to-date compared to an average peer group return of 4.33 per cent, ranking the fund first quartile in its sector, say European high yield – which has been outperforming the US since mid-2012 – has become even more expensive following the European Central Bank’s attempt to boost inflation in early June.
“The ECB’s move into negative interest rates has heightened the demand for yield, increasing flows into the European high yield asset class,” says Milburn. “While the absolute flows into US or global high yield have been greater in recent years, relative to the size of each market flows have been proportionately higher in Europe.”
There has also been more ‘supply cannibalisation’ in the US, with issuers frequently choosing to issue leveraged loans rather than bonds.
“In Europe, the banks are still deleveraging, and we see more supply from loan-to-bond refinancing,” says Milburn. “This has led to some supply of questionable quality, as the banks have been keen to rid themselves of some of their riskier loans and the market has digested some issuers of which it has no real knowledge or experience. Most of these will prove to be fine, but some sectors and segments will struggle if companies report disappointing results and when the default cycle turns.”
Furthermore, with Europe a less mature high-yield market than the US, there has been less push-back against ‘covenant degradation’, the increase in terms that are highly favourable to the issuers and private equity firms, but which are disadvantageous to conventional investors.
“Both sides of the Atlantic now have poorer-quality covenants than in the past, but only in Europe have we seen widespread use of change-of-control exemptions, which severely limit the situations in which investors can sell back bonds,” says Milburn.
While their current preference for the US over Europe is underpinned by valuation – with most of the total return in high yield coming from income, the managers favour the higher-yielding market – they do not rule out buying back into Europe in the coming months.
”Given the recent growth in the European high yield market, money is more likely to flow out of it when the market next turns – which could quickly take the asset class back to attractive levels,” says Milburn.
However, he points out that a market turn is not a prerequisite for their current portfolio positioning to pay off.
“Given a yield differential of 1.5 percentage points, the European market would need to add about 10 cents of relative outperformance in capital growth every month to catch up with the US, which looks a big challenge with current cash prices where they are,” he says.
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