Europe is a relatively attractive market to be in right now for investors seeking returns from their fixed income solutions. The US economy, for example, is firmly mid-cycle, while Europe is just entering its recovery phase. Historically, early-stage recoveries have been an optimal time in which to allocate money to credit markets, particularly high yield. So where are the opportunities likely to arise in 2014? The author believes that high-yield corporates will be an important source of value added.
Euro high yield has presented investors with spectacular returns over recent years. The obvious question is: Is there anything left? Perhaps not on the scale that has been seen before now, but nonetheless we estimate that a return of between 6% and 8% is realistic in 2014.
The financial sector has been one of the biggest sources of opportunities for the group in the high-yield market in recent years, and further developments can be expected in 2014. As the Basel III capital adequacy regime is implemented, financial institutions (FIs) will be required to bolster the core capital that they have in place. This will be achieved through the restructuring of their balance sheets and the issuance of new style Tier 1 debt (Additional Tier 1, or AT1).
These new issues are likely to be priced at more attractive levels than existing issues. But demand may not be aggressive because not all investors can buy them. They will be largely off-limits for insurance companies, for example. So other investors are in a perfect position to take advantage of this source of added value for at least the next one or two years.
Small may be Beautiful
Another focus for us is on the smaller names – an area where research is likely to be well rewarded. The post-2008 influx of new issuers in the market has, more recently, been joined by smaller players who are attracted by robust investor demand and low borrowing costs. These either may not be part of an index at all, or may represent a very low percentage of the index. So not all fund managers will have the research capacity or the inclination to cover them.
Currently, the group sees little value in the large issuers that make up the larger percentage of the market index, as these have been squeezed to unattractive levels. In our view, some of the smaller names are very attractively valued. Diversification, of course, will be crucial. To avoid owning too great a percentage of any issue, the smaller the issue size, the lower the percentage weighting each security should represent
In short, the easy money has been made, but there are still attractive opportunities to be found. The key thing for the investor to remember in 2014 is that returns will depend much more heavily on manager skill through sector and security selection this year. In other words, just having broad market exposure will no longer be enough to ensure attractive returns.
We think we’re going to see a big divergence in the best- and worst-performing euro high-yield managers in 2014 and into 2015 – driven by security selection.
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