- Fixed Income Portfolio Manager
France, Intermediary
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European high yield markets have come under significant pressure this year. While I think investors should brace themselves for further volatility, I believe the long-term case for European high yield remains robust, with new opportunities beginning to emerge.
Deciphering the challenging backdrop
There are many risks present in global markets currently, including persistent inflation, the energy crisis in Europe and geopolitical concerns relating to Russia’s invasion of Ukraine. In my view, the combination of these risks is likely to translate into a potentially extended period of below-trend growth. However, as a team, we do not see a deep global recession as our base case. Governments across Europe have stepped in to shield consumers and companies from the full impact of rising energy prices. Further, the banking system is more solid than it has been in the recent past. Central banks are highly attuned to the risks associated with weaning economies off ultra-low interest rates. Consequently, I expect a slowdown that is akin to a week of blustery showers rather than a hurricane.
The market opportunity
While accidents along the way cannot be excluded given today’s geopolitical instability and the impact of reduced liquidity, from my perspective this environment does not imply the full-scale default cycle that the market is anticipating. Based on current price and spread levels, market participants are forecasting a five-year cumulative breakeven default rate of approximately 41%1 in European high yield, which, if realised, would be the largest default cycle on record. I consider these default projections as overly punitive, particularly given credit fundamentals for Euro high-yield issuers remain intact. Instead, I expect the five-year cumulative default rate to be more in line with the historical average (approximately 16%), suggesting there may be opportunities to add to solid high-yield issuers at attractive price levels.
This year’s sell-off has brought valuations to historically attractive levels, creating a good entry point for long-term investors. Figure 1 depicts the historical three-year forward excess returns at various spread levels. Historically, when euro high-yield spreads have been between 485 and 768 basis points, investors have experienced excess returns of over 7% on a three-year forward-looking basis.
Figure 1
Protecting portfolios through the volatility
While I do not expect default rates to rise to recessionary levels, I anticipate further uncertainty and volatility. In this type of environment, deep, bottom-up fundamental research is important in identifying the issuers with sustainable cash flows to weather the heightened volatility.
In our portfolios, we rely on Morningstar’s Moat framework to determine whether a company has a sustainable competitive advantage or “moat”. This framework focuses on five moats — such as having a cost advantage that is hard to replicate or benefiting from high-quality intangible assets such as a brand or patent — as illustrated in Figure 2. We tend to avoid companies that do not possess any of these moats as, in our opinion, they are unlikely to outperform over the long term.
Figure 2
This process allows us to gauge a company’s long-term potential. For example, Netflix is a company that we have a negative view on primarily because of the low “switching costs” in the sector. It is very easy for subscribers to move from one provider to another, given there are multiple streaming services available at very similar prices. Netflix has very low leverage levels but has consistently been unable to generate cash flows. Therefore, we believe the company will need to keep spending capex on content to stop subscribers leaving. Meanwhile, Cellnex (a telecommunications tower operator) is a company we like because of its “efficient scale”. The company has a strong network, which is extremely expensive to replicate. Because of this, it would be challenging for another company to enter the market. The company also has a business model that allows it to tolerate higher leverage — our expectation is that Cellnex can sustain 6 – 7x leverage.
We complement this moat framework with a wide range of other perspectives — most notably an ESG lens — to help us look through short-term market concerns and determine which issuers we like from a bottom-up perspective. From a defensive angle, we look to avoid sectors or geographies that are increasing in capacity as we believe these areas will experience higher default rates if the cycle turns. For instance, we are cautious on the semiconductor sector as our research suggests that the China/Taiwan geopolitical conflict has resulted in overcapacity of semiconductors, particularly in Europe.
Finding the right balance
I recognise that there are many risks to the economic outlook and further volatility is likely in the near-term. At the same time, I see opportunities emerging, particularly for investors willing to do the research and venture into “out-of-favour” areas of the market when the time is right. Doing so, I believe, can help position portfolios away from those assets that are most vulnerable to potential downside, as well as help ensure readiness for eventual “market snapbacks” that could occur if macro conditions improve.
Why the Wellington Euro High Yield Bond Fund?
- A time-tested philosophy and process
The current uncertain environment presents an opportunity for active managers combining a time-tested investment process with an opportunistic approach to generate meaningful alpha for clients.
- Leveraging Wellington’s global resources
We believe that the integration of insights from our macro, equity and ESG research analysts, who focus on meaningful engagement with issuers, can allow us to form a well-rounded opinion of sector dynamics and issuer health, supporting our security selection process.
- Long-term performance
The Fund has delivered strong peer and benchmark relative performance since inception. It has also received a Morningstar 5-star rating.
Please refer to the sustainability-related disclosures for information on the commitments of the portfolio: https://www.wellington.com/en-gb/intermediary/sustainability/sustainable-finance-disclosure-regulation
1Source: Bloomberg. Data as of 31 October 2022.
©2022 Morningstar, Inc. All rights reserved. The information contained herein: (a) is proprietary to Morningstar and/or its content providers; (b) may not be copied or distributed; and (c) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Rating as of 31 October 2022. Past performance does not predict future returns. Rating is based on EUR N Acc. Ratings are not a recommendation.
The investment case studies presented are for illustrative purposes only. The case studies chosen are based on topics that we think give insight into our process. There can be no assurance we will continue to hold these companies and that they will be profitable in the future. The individual issuers listed should not be considered a recommendation to buy or sell. Please refer to the annual and semi-annual report for the full holdings.
Consider the risks
Investors should consider the risks that may impact their capital, before investing. The value of your investment may fluctuate from the time of the original investment. A decision to invest should consider all characteristics and objectives as described in the prospectus and KIID.
Risks
BELOW INVESTMENT GRADE: Lower-rated or unrated securities may have a significantly greater risk of default than investment-grade securities, can be more volatile, less liquid and involve higher transaction costs. CAPITAL: Investment markets are subject to economic, regulatory, market sentiment and political risks. All investors should consider the risks that may impact their capital, before investing. The value of your investment may become worth more or less than at the time of the original investment. The Fund may experience a high volatility from time to time. CREDIT: The value of a bond may decline, or the issuer/guarantor may fail to meet payment obligations. Typically, lower-rated bonds carry a greater degree of credit risk than higher-rated bonds. HEDGING: Any hedging strategy using derivatives may not achieve a perfect hedge. INTEREST RATES: The value of bonds tends to decline as interest rates rise. The change in value is greater for longer-term than shorter-term bonds. MANAGER: Investment performance depends on the investment management team and their investment strategies. If the strategies do not perform as expected, if opportunities to implement them do not arise, or if the team does not implement its investment strategies successfully, a fund may underperform or experience losses. SUSTAINABILITY: A sustainability risk can be defined as an environmental, social or governance event or condition that, if it occurs, could cause an actual or potential material negative impact on the value of an investment.
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