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Yield of dreams

The European high-yield market is still immature in relation to its US counterpart but it has grown rapidly over the last few years.

This growth has come principally as a result of the sweeping changes in European business and investment markets. Europe is now a common-currency trading bloc. This is encouraging both increased competition and opportunity.

Industries are also deregulating and this brings additional growth opportunities. This is manifesting itself in a wave of restructuring and mergers sweeping European industry, with companies increasingly concentrating on core competencies, assembling pan-European platforms and selling non-core assets.

Changing times in Europe means more issues of high-yield bonds The emergence of a more competitive marketplace is leading companies to review their strategic options. This is being exacerbated by the rising cost of capital.

European companies have historically been dependent on bank loans as a source of cheap finance. This puts them in a vulnerable position if bank finance becomes less available or more expensive – a scenario we believe is probable in current conditions as the banking sector consolidates and is forced to focus on return on capital.

Alternative sources of finance will be more rationally priced and will have to come from the capital markets. We see highyield bonds playing an increasingly significant role.

High yield is a different asset class

High yield has distinct characteristics that make it a separate asset class.

Financial advisers will, we believe, get increasingly comfortable with the uses of highyield bonds, as the US has in the last 15 years. Because the European market is so young, we have to use US data as an example but the European market has started to develop along similar lines to the US and there are good reasons to believe this will continue.

The first point to make is the relatively low correlation between high yield and other asset classes in volatility. Government bonds are influenced more by interest rate and inflation expectations while high-yield bonds are affected by fears about corporate strength as well as interest rates.

The table above shows the correlation between the monthly returns from different asset classes. You can see that the correlation between highyield and investment-grade corp- orate bonds has been just 0.54 per cent compared with a correlation of 0.78 per cent between equity groups as represented by the S&P 500 and the Nasdaq. High yield&#39s correlation with equities has been even lower at 0.50 per cent with the S&P 500 and 0.48 per cent with Nasdaq.

Because high-yield returns are not closely correlated with other market returns, adding high yield to a holding of Government bonds can serve to decrease the volatility of the returns on the portfolio as a whole while also raising the expected return of the portfolio.

The chart above illustrates what is called the efficient frontier of different combinations of high-yield and Government bonds.

Unsurprisingly, point A at the top right shows that a 100 per cent weighting in high yield delivers good returns but also higher risk.

A 100 per cent weighting in Government bonds – point C – has delivered lower returns with lower risk. But there is a range – up to about 45 per cent – when holding highyield bonds reduces volatility while increasing returns. The best mix for minimising volatility occurs at point B, which equates to a weighting of around 30 per cent in highyield bonds.

At the same time, a weighting of 45 per cent would expose investors to the same degree of volatility as a full weighting in Government bonds but with far superior returns. Remember that the chart is drawn using data taken from the well established US market.

Combining these asset class characteristics of low correlation and attractive riskadjusted returns, high yield can work very effectively in terms of portfolio construction, enhancing yields in times of yield starvation within an acceptable portfolio risk context.

As such, high yield is an asset class that is attractive to long-term investors and, using the US experience again, it is certainly long-term investors who dominate that market.

We consider the global high-yield market is very much an asset-allocation consideration for European investors since it is based in local currencies and is more relevant in terms of economic backdrop.

The outlook

So, what has happened recently? While 1999 was very strong in performance terms, 2000 was much more difficult.

In November and December, high-yield bonds spiked sharply down as fear of default caused panic. Much of this was due to the performance of TMT in the capital markets or MT in the high-yield sphere since the nature of technology assets means that this sector is not represented significantly in the high-yield market.

We consider that high yield will perform well this year. Current yield levels of 14 per cent and above look attractive and compensate investors for credit risks being taken.

Defaults will tick up from low levels but we do not consider that this is a major issue considering the high current yield levels and a relatively benign macroeconomic outlook in the UK and Europe.

Historically in the US, high yield has provided long-term returns that have more than compensated for its extra volatility. In other words, many investors have been too anxious about high yield.

High yield as an asset class provides a yield solution in a low-yield environment and also works well in a portfolio context for long-term investors.

This asset class is new to Europe and provides investors with an exciting opportunity to invest in the long-term restructuring of Europe&#39s industrial base.


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