European High-Yield Debt is Still Not Cheap Enough: Analysis

HY breaks through 2012 level vs IG as risks intensify

After the volatility and spread weakness experienced across financial markets in these early weeks of 2016, generic European sub-investment grade corporate debt is now quoted at its cheapest level in four years relative to its investment grade sibling. Nevertheless, there is little evidence as yet of real-money investors seeing this as a buying opportunity, writes Bloomberg strategist Simon Ballard.

Spread between EUOAIGTO Index and EUOHHYTO Index
Spread between EUOAIGTO Index and EUOHHYTO Index

The spread between the European investment grade and high yield cash bond credit indexes is currently around 486 basis points, breaking through the January 2012 level, when the spread reached 482 basis points. While current valuations may appear optically appealing, several factors continue to damp risk tolerance. These include the overhang of global macroeconomic uncertainty, commodity and oil price volatility as well as the consequences of the economic slowdown in China. All of these are helping to keep a lid on risk appetite, albeit with no investor capitulation.

Underlying much of the market's fragility is the persistent concern over the lack of (secondary market) liquidity. This in turn is fuelling fears of a possible implosion in asset prices should offer-side price interest continue to gain momentum, at a time when the street is unable to absorb unlimited inventory due to evolving regulatory environment. A more bearish market environment, characterised by blanket better selling cares, would suggest that corporate spreads would have to offer significant concessions to investors in higher risk sectors.

The primary market is really the only tradable sector of corporate credit at moment and even that is now facing increased investor scrutiny, as reflected in new issue price performance that has been increasingly mixed in recent weeks. No syndicate desk wants to bring first deal to be labelled ‘fail’.

Negative sentiment/risk aversion begets risk aversion/negative sentiment, but cheapening risk-asset valuations will create a buying opportunity at some stage. As always though, timing and issuer/issue selection will be key to executing the entry point; we may not be there yet.

Investors may soon focus attention on implied oversold assets, while maintaining a bias for robust fundamentals and continuing to minimize exposure to energy, commodities, higher beta and duration.

Note: Simon Ballard is a credit strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

 

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