Euro High-Yield (EHY) Corporate Bond Views—Q1 2021

    Franklin Templeton Fixed Income

    Despite the extraordinary events that characterized 2020, remarkably, the euro high-yield corporate market is expected to close the year not far from where we, and most market participants, forecasted at the beginning of 2020. We entered 2020 with a modestly bearish outlook as we expected EHY spreads to widen during the year. We thought EHY default rates were going to rise, albeit from historically low levels, because of the loss of momentum in the European economy and high leverage multiples prevailing in some areas of the EHY market.

    Fast-forward 12 months, EHY credit spreads are, in fact, likely to end the year slightly wider compared to the beginning of the year. 2020 absolute returns are expected to end in positive territory, slightly below the beginning of the year’s average coupon. Obviously, none of us expected to reach such yearly performance through the ups and down of the COVID-19 pandemic. With most major economies in a standstill by the end of March, it is no wonder the market priced in a sharp rise in EHY default rates. In April and May, credit ratings agencies were busy downgrading both euro investment grade (IG) and high-yield issuers as they penciled in a very bearish forecast for 2020.

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    However, it soon became clear that the COVID-19 pandemic was not going to hit economic activity evenly. In fact, most manufacturing companies, after adjusting their production processes to align with the new health protocols dictated by the pandemic, quickly rebounded as consumer spending remained healthy. The quick recovery of the Chinese economy also meant that fears of major supply-chain disruptions were overdone. With retail saving rates rising to record high levels due to mobility restrictions and government support measures, what was not spent in travel and leisure went, above all, into durable goods purchases. On the other hand, hopes for a modest second half of the year recovery in air travel and leisure quickly faded as infection rates started rising again in the summer.

    Despite EHY spreads retracing strongly since the beginning of April, we expect the EHY to end the year among the lowest-performing asset classes in 2020. Characteristically lower duration and increasing default rates had a negative impact on both the relative and absolute performance of the EHY market. Additionally, the market grew at a record rate in 2020, up over €120 billion. Such record growth was possible due to a rise in “Fallen Angels” (mostly IG issuers directly impacted by the pandemic) and a very large primary market issuance, as the EHY bond market gained market share versus the European leveraged loan market. The strong market growth was met with tepid demand from pure EHY products as EHY dedicated funds did not see commensurate inflows as other markets, such as US high yield. Instead, during the summer months, participation of non-dedicated EHY accounts buying into the EHY market began to grow, seeking higher yield amid historically low euro sovereign and IG yields.

    We are entering 2021 with optimism but are conscientious that the rollout of the various vaccines approved or likely to be approved will be a long process. As infection rates remain high across most major countries, we are expecting at least another quarter of constrained economic growth, but we are hopeful for a turn for the better during the second half of 2021. Similarly, with the ECB and most major central banks remaining accommodative, and euro sovereign yields likely to persist at historically low levels, we expect demand for higher-yielding products, particularly in the euro area, to remain at an all-time high. With such a constructive backdrop, but also factoring existing tight credit spreads and risks associated with complacency and euphoria, we believe an upgrade from moderately bearish to a neutral outlook on euro high yield is warranted following the release of the first Pfizer/BioNTech vaccine.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

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