Talking Heads – Short maturity European high-yield bonds: a promising blend

This is an audio transcript of the Talking Heads podcast episode – European high-yield and short duration: a promising blend  

ANDREW CRAIG: Hello and welcome to the BNP Paribas Asset Management Talking Heads Podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing short duration, high-yield debt. That’s to say, bonds rated below triple B minus, also known as junk bonds. They’re not investment-grade bonds as they have a higher risk of defaulting. To offset that risk, high-yield bonds generally offer investors a higher yield than better rated bonds. I’m Andrew Craig, Co-head of the Investment Insights Centre, and I’m joined today by Stef Abelli, who is European High Yield Portfolio Manager with a particular focus on short duration, high yield debt in our London office. Welcome, Stefan. Thanks for joining me.  

STEF ABELLI: Thank you for having me. 

AC: To begin with, can you explain to us what is meant by a short duration high yield strategy? 

SA: What you’re doing is investing only in bonds that have a shorter expected maturity. You are looking at bonds with an expected maturity below three years. The benchmark will be between one and three years. And that’s important because when you’re investing in high-yield, you want to make sure that the companies that you’re investing in have cash flows that are commensurate to the debt service. If you have a shorter-term horizon, you can have greater certainty on what are the cash flows of these companies. The product should have, for that reason, a slightly lower volatility. And it should also have a lower correlation to interest rates.  

There are a number of advantages. You have the high visibility on the development of the cash flows of the issuers. It’s easier to forecast what is going to happen over the next few years. You have this low volatility, low correlation to interest rates, plus often near-term catalysts. They may have a ‘pull to power’. Basically, the bonds are trading at a discount and will repay you at par when maturity comes. I think it’s a very interesting asset class.  

AC: What we’re saying is that if you have a relatively short investment horizon, you have better visibility on what the risks are that these companies are exposed to? 

SA: Exactly. You’re lending money to companies and it’s easier to forecast what’s going to happen between now and 2026, 2027, say, than to forecast the next 10 or 20 years.  

AC: Let’s talk about your current views on the asset class. How do you see the state of the asset class? 

SA: I’m constructive. First, it’s a rather simple credit product. A significant part of our return is income return. It’s money now on the table. The company will at maturity of the bonds [pay you out] and in the meantime you get annual income in the form of the coupon. There’s potential upside. I think it’s an interesting income kicker for any portfolio. Usually, people tend to think of this asset class in terms of metrics. There is this continuous debate: spreads are much tighter than average, etc.  

Spreads have tightened over the last couple of years. Companies have been extremely cautious and have also shelved plans to refinance because they could continue to pay slightly lower coupons. So why go back in the market? We should be looking at the yield and assume that companies will be refinancing this debt at higher coupon when the time comes. No need to worry, really. The other supportive factor is that rates have peaked. There are questions related to the number of rate cuts. The ECB has already started to cut. The peak in interest rates is indisputable. The economy in Europe is expected to return to growth, even if slowly, and default rates are expected to be quite low. Overall, these are all the right conditions to invest in short duration high-yield.  

AC: Let’s talk about the sort of return that we should expect in 2024 from short duration high-yield. What do you expect and what does the market base its prediction on for the return this year? 

SA: At the beginning of the year, we had consensus expectations for a return for high-yield of 7-8%. So, if you take a haircut to that because short duration is assumed to have a slightly lower risk and therefore a just slightly lower return, you could get to 6%. If you look at the current yield for the short duration index that excludes triple C, it is 5.8%. If nothing else changes, you should expect the return to hover around that number. To date, the return has been 3%, so we would be repeating approximately what we have done so far in an environment where there’s effectively little volatility because conditions are well known.  

AC: There’s a lot of demand, a search for yield, a search for returns. You could say that for European investment-grade credit or European sovereign bonds, the yields are relatively low. High-yield is one sector within the European bond markets that offers [a higher yield].  

SA: You’re making a good point. We continue to see inflow in the asset class in general. There is definitely cash looking for a home. There is pressure for prices to continue to stay at similar levels. So,  there’s no reason for spreads to widen. Just to give you an idea, when we have [new issues], the books are multiple times oversubscribed, which gives you a good understanding of the demand for these bonds.  

AC: If we move on to the risks around high-yield some investors are wary of, default is a clear risk. What are the reasons that [investors] should not be overly wary? Can you talk us through some of those factors? 

SA: High-yield carries a slightly higher risk and gives you a slightly higher return. For high yield, the risk is default risk, which is a situation in which the company cannot anymore service the debt. The reality is default risk is easily identifiable. You can see [default] slowly escalating [at] companies with excessive leverage [and] limited access to markets. They are altogether avoidable. The other thing to take into account is that the European high-yield market is dominated by strong BB [ratings] and in particular a large component of hybrid bonds, which are effectively bonds in the lower part of the capital structure of investment-grade companies. For these bonds, there’s what it’s called extension risk, but no default risk. The European high-yield market is more vanilla.  

AC: It’s a different animal to, for example, the US high-yield bond market in terms of its structure and the nature of the companies.  

SA: Exactly. We tend to be, in Europe, more cautious.  

AC: When you talk about extension risk, we’re talking about the risk that the issuer extends the maturity of their issue. Is that right? 

SA: This is possible in hybrid bonds. Great companies would altogether try to avoid this because it impinges on their reputation.  

AC: Your role is to select those companies where you consider the risk is limited and the perspectives over the short maturity horizon are positive, and avoid those whose prospects are not good. What does that lead you to conclude for the sectors that you find attractive? 

SA: Real estate has been hit by the increase in [interest] rates and combined with a dearth of mergers and acquisitions. The cut in [ECB} rates that we have seen already today [should help]. The lower your interest rates, the better off this these issuers will be. Real estate is one of our favourite sectors at the moment. We also like the so-called A1 bonds that are rated high-yield because of their position in the capital structure of the [issuing] banks. They offer much higher returns for a risk that I deem limited because we tend to invest in strong national champions, banks that are well-capitalised. Finally, there are sectors that have suffered in a skyrocketing inflation environment and will benefit from inflation receding. These are mainly services and consumer sectors. The services sectors has suffered from an inability to pass through inflation. The consumer sector has suffered from weak consumer confidence and lower disposable incomes in Europe. This is a question of reversal of abnormal moves generated by an inflationary environment. At the moment, the environment is conducive to the sectors that I mentioned. 

AC: Thank you for joining me, Stef.  

SA: Thank you too.