Big Investors Lose Faith in Europe's ECB-Fuelled Junk Rally
(Bloomberg) -- Some of Europe’s biggest money managers are getting ready for a turnaround in the two-year bull run of the continent’s riskiest corporate debt.
Deutsche Asset Management has reduced holdings of European junk bonds in its 100 billion euro ($106 billion) multi-asset portfolios and JPMorgan Asset Management says investors should brace for a tough second half. BlackRock Inc. says risks for European credit are tilted to the downside and Nataxis SA recommends dialing back high-yield debt exposure.
Market participants are sounding the alarm bells as the European Central Bank prepares to scale back its 60-billion euro monthly bond purchases. High-yield debt has become one of the biggest beneficiaries of the stimulus, which compressed spreads in better-quality bonds, forcing investors to seek returns elsewhere. The risk now is that that trend will reverse.
“We could be in for a prolonged period of readjustment as European fixed-income investors adjust to a world where the ECB is tightening monetary policy,” said Alex Dryden, a London-based global-markets strategist at JPMorgan Asset Management, which oversees $1.9 trillion. “The yields now have got to such a level where we don’t believe that you are being compensated for the risk that you are taking on.”
Policy makers are preparing for a debate in the autumn about the future path of quantitative easing after ECB President Mario Draghi expressed confidence that the recovery was solid, broad-based and sustainable.
Although the bond-buying program has only included high-grade debt, the crowding-out effect that is pushing investors to riskier securities has reduced the spread between European high-yield and investment-grade bonds to 2.3 percent, 100 basis points lower than when the quantitative easing program began. New issuance spread premiums in the corporate bond market have narrowed every year in that time, even as volumes surged.
Any rise in yields could be exacerbated by issuers rushing to lock in funding before borrowing costs increase further, resulting in a deluge in the final few months of the year. More than 870 billion euros of corporate debt has already been issued by European companies this year, a 12 percent rise from the same period in 2016, according to data compiled by Bloomberg.
Debt issued by companies with fragile balance sheets typically outperforms investment-grade bonds when rates rise, as better economic growth boosts risk appetite and corporate earnings. But this cycle is different because years of monetary stimulus have elevated the sensitivity of credit markets to the ebbs and flows of government bonds, analysts at JPMorgan Chase & Co. wrote in a recent research note.
Olivier Monnoyeur, a London-based high-yield portfolio manager at BNP Paribas Asset Management, is less pessimistic, saying that yields have potential to fall further as the euro-area economy continues to adjust to a healthier environment.
“What really matters is the speed and the process and how disruptive it is,” Monnoyeur said. “If it’s a prolonged, steady retreat from QE, I think high yield can be OK.”
Deutsche Asset Management is shifting its focus to equities, where there is more potential upside and higher yields from dividends, according to Christian Hille, the Frankfurt-based global head of multi asset. Once concern is that spreads for high-yield debt have dropped below the trailing 12-month default rate for the sector, which rose to 2.4 percent in July, according to S&P Global Ratings.
JPMorgan’s Dryden sees more value in U.S. junk debt, and also recommends emerging markets as a source of portfolio return.
“European high-yield could be set for a tough second half of the year considering the broader macro environment,” Dryden said. “Right now I see better opportunities elsewhere.”