European high yield bonds have outperformed US high yield bonds recently due to stronger economic recovery in Europe. However, risks remain for European high yield from slowing global growth, particularly from China, and from a potential reversal in investor flows. Defaults have increased in the energy sector due to low oil prices, which poses ongoing risks, though energy makes up a smaller portion of the European high yield market than the US market. Overall liquidity risks remain elevated across fixed income markets.

1. European high yield is
resilient, but risks are
looming
Tim Dowling
Head of Credit Investments & Lead Portfolio Manager
Global High Yield

2. High yield (HY) as an asset class encountered a challenging global environment in the third quarter, mostly
the result of a rise in risk aversion among investors. Risky assets such as HY bonds reacted negatively to
fears of a perceived global economic growth slowdown led by the world’s second largest economy, China.
HY returns were accompanied by an unusually large divergence
between regions. Returns in Europe significantly outperformed those in
the US, as the market welcomed a compromise outcome to the latest
phase of the Greek crisis and signs of a sustained economic recovery.
US returns were weak, particularly lower down the rating scale. The
underperformance of US HY bonds can be mainly explained by the
importance in the benchmark of issuers present in the energy and
material markets. More generally, energy, commodity and global
growth related credits underperformed on the back of increased
worries on Chinese, emerging markets and global growth and falling
commodity prices. From a credit quality point of view, there was a
clear risk-off trend: higher quality credits outperformed lower quality
credits.
In the past months, we witnessed a number of defaults in the US
energy sector. Low oil, natural gas and coal prices have caused
defaults in the energy and metals & mining sectors, and we believe
further defaults will follow. Fortunately, outside these sectors the
default rates remain low, but sentiment for US high yield is unlikely to
improve much in the near term as these sectors are sizeable. A key
trigger for a reversal would be a bottoming of commodity prices and
oil prices in particular.
European high yield is not completely sheltered
In the current environment it is difficult to imagine that the European
HY debt category would be completely sheltered from the severe
headwinds facing its US counterpart. Indeed, lower oil prices will lead
to more defaults in the energy sector. However, this especially holds
for the US. The energy sector is about 15% of the US HY market,
whereas in Europe the exposure is not more than 2%.
Perhaps a greater risk to European HY are investment flows, which are
probably even more important for European than for US HY paper.
Whereas US HY has witnessed outflows this year and last, European
HY attracted +16% of assets under management in inflows so far in
2015, after inflows of +10% in 2014. Sentiment reversals and
subsequent investor outflows are of course potential headwinds for
HY paper in the US as well as in Europe. But given market
capitalization and historic inflows, they probably pose a bigger threat
to European HY. At a time with low market liquidity in spread products,
investor flows can carry a big impact. And while European paper has
outperformed US in the HY category, contagion risk has recently
increased.
The liquidity risk is – to a large extent – priced in. Part of the widening
in spreads reflects the need for more compensation to cover the
increased cost of entering or exiting the credit markets associated
with the decline in dealer-provided liquidity. Although the lower
liquidity conditions are not expected to result in any type of systemic
stress, volatility in fixed income returns will most likely be higher than
in the past. Considering that the factors creating lower liquidity
conditions in the fixed income markets are not about to reverse, the
larger, more liquid bonds are looking more attractive than the less
liquid types of paper. The premium required to own smaller issues has
increased and we think many of these smaller issues are very
attractive at today’s lower prices.
Impact of Chinese slowdown and Fed normalisation
It will be interesting to see if European HY can continue to outperform
its US peer. European earnings and macroeconomic data are still
resilient which offers support to European HY, as does the low
gov-ernment bond yields in the region. A big challenge for HY
investors is to assess the impact of the Chinese slowdown on
developed market economies. Limited danger is seen to US exports,
as they are a small percentage of GDP, and a greater threat to the
more export dependent European economy. Cheaper goods and
commodity prices in the developed markets benefit consumers, but
also depress an already low inflation environment.
Additional areas of uncertainty include the behaviour of Chinese policy
makers. For example, if the Chinese authorities choose to maintain the
exchange rate stable vis-à-vis the US dollar, they are likely to sell part
of their Treasury holdings, leading to an increase in US bond yields.
Other key concerns include the divergence in monetary policies, with
the Federal Reserve potentially tightening while the rest of the world is
easing, and the impact of that divergence on the US dollar and the US
economy. European QE could push bond buyers down the rating
ladder, preserving better technical market conditions in Europe than
the Fed-focused US.
Tim Dowling
Head of Credit Investments &
Lead Portfolio Manager Global
High Yield

3. About NN Investment Partners
NN Investment Partners is the asset manager of NN Group N.V., a publicly traded corporation. NN
Investment Partners is head-quartered in The Hague, The Netherlands. NN Investment Partners
manages in aggregate approximately EUR 184 bln* (USD 206 bln*) in assets for institutions and
individual investors worldwide. NN Investment Partners employs over 1,100 staff and is active in 16
countries across Europe, Middle East, Asia and U.S.
As of April 07, ING Investment Management has renamed to NN Investment Partners. NN
Investment Partners is part of NN Group N.V., a publicly traded corporation. Currently NN Group is
37.1% owned by ING Group. ING intends to divest the remaining stake in NN Group before 31
December 2016, in line with the timeline ING has agreed with the European Commission.”
*Figures as of 30 June 2015
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