At the beginning of this year, the European high yield bond market, represented by the Bank of America Merrill Lynch European Currency High Yield Index, was yielding 3.5%. The U.S. market, represented by the BofA ML U.S. High Yield Master II Index, was yielding 6.2%. Emerging markets corporate bonds, represented by the BofA ML Emerging Markets Corporate Plus Index, were yielding 4.5%.
Which of these three markets had generated the highest hedged returns by the end of August this year?
Kudos to those who guessed that it was European high yield, with 6.8%. Emerging markets corporates returned 6.2% and U.S. high yield 6.1%.
Even more kudos to those who know that tightening credit spreads were not the primary reason for Europe’s outperformance. Spreads have tightened—but nothing like enough to cover the 270 basis points that stood between European and U.S. yields in January. To understand what really happened, focus on the key word in the question: “hedged.”
A Distorted View
With almost 300 extra basis points up for grabs, why wouldn’t a European investor shun domestic high yield for U.S. high yield?
The answer is that buying bonds denominated in U.S. dollars creates a foreign currency exposure which most investors will hedge using the forwards market, and that this incurs a cost, equal to the difference between the interest rates for dollars and euros at the point on the curve at which the forward contract expires.
Right now, with the European Central Bank holding at negative rates and the Federal Reserve nearly two years into its rate-hike cycle, that difference is some 50 basis points for a three-month EURUSD forward, or more than 200 basis points annualized. A full currency hedge would therefore have wiped out a substantial part of the 270-basis-point yield advantage that U.S. bonds appeared to promise at the start of the year. The flipside, of course, is that a hedged U.S. investor buying European high yield bonds has been gaining 190 basis points, annualized, making up for most of the apparently lower yield on the bonds.
In other words, the yield differential observed at the top of this page was largely accounted for by the difference between the euro and dollar risk-free rates, which was also the determinant of the cost of (or gain from) currency hedging.
What do we learn from this?
First, to be alive to the advantage of diversifying our high yield portfolio regionally—a wider universe of opportunity is especially useful in our search for returns when valuations are stretched everywhere.
And second, while interest rate differentials are so wide and credit spreads are so tight, to take extra care not to allow the economics of currency hedging to distort our view of the regional relative-value situation.
Don’t Miss Out
We have long advocated diversifying into European high yield bonds, and indeed loans. For 10 years, European high yield has been the standout performer in global credit. In that time it has grown to 20% of the global high yield market, primarily due to a combination of investment-grade issuers being downgraded to BB in the aftermath of the financial crisis, and more companies seeking to diversify their borrowing away from bank loans.
As a result, 70% of issuers in the European Currency Index are rated BB, compared with around 46% in the U.S. Index. As well as higher credit quality, European high yield generally exhibits shorter duration and a markedly different sector profile: It is much more exposed to banking and the auto sector, for example, while the U.S. index carries much more energy and health care. This led to substantial divergence in performance during the oil price collapse of 2014-15, for example.
It is easy to assume that European issuers’ high quality, against an increasingly robust economic backdrop, accounts for the apparently lower yields on offer there. But, whenever you compare two regional credit markets, remember to factor in the differentials in risk-free rates and the consequent costs of currency hedging. Otherwise you could miss out, not only on a potential diversification benefit, but on the high yield sector’s best returns.
In Case You Missed It
- NAHB Housing Market Index: -3 to 64 in September
- Eurozone Consumer Price Index: +0.3% in August month-over-month and +1.5% year-over-year
- U.S. Housing Starts: -0.8% to SAAR of 1.18 million units in August
- U.S. Building Permits: +5.7% to SAAR of 1.30 million units in August
- U.S. Existing Home Sales: -1.7% to SAAR of 5.35 million units in August
- FOMC Meeting: Balance sheet normalization to begin in October; one more rate hike expected in 2017
What to Watch For
- Tuesday, 9/26:
- Case-Shiller Home Prices
- U.S. New Home Sales
- U.S. Consumer Confidence
- Wednesday, 9/27:
- U.S. Durable Goods Orders
- Thursday, 9/28:
- U.S. 2Q 2017 GDP (third estimate)
- Friday, 9/29:
- U.S. Personal Income & Outlays
Statistics on the Current State of the Market – as of September 22, 2017
|S&P 500 Index||0.1%||1.3%||13.4%|
|Russell 1000 Index||0.2%||1.4%||13.3%|
|Russell 1000 Growth Index||-0.2%||0.6%||19.9%|
|Russell 1000 Value Index||0.5%||2.2%||7.1%|
|Russell 2000 Index||1.3%||3.3%||7.9%|
|MSCI World Index||0.4%||1.9%||16.1%|
|MSCI EAFE Index||0.7%||2.5%||20.5%|
|MSCI Emerging Markets Index||0.0%||1.5%||30.5%|
|STOXX Europe 600||0.7%||3.2%||23.1%|
|FTSE 100 Index||1.3%||-1.5%||5.7%|
|CSI 300 Index||0.2%||0.5%||18.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||-0.1%||-0.1%||0.6%|
|Citigroup 10-Year Treasury Index||-0.5%||-1.1%||2.9%|
|Bloomberg Barclays Municipal Bond Index||-0.2%||-0.2%||5.0%|
|Bloomberg Barclays US Aggregate Bond Index||-0.1%||-0.4%||3.2%|
|Bloomberg Barclays Global Aggregate Index||-0.3%||-0.2%||7.0%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.0%||0.3%||2.2%|
|BofA Merrill Lynch U.S. High Yield Index||0.2%||0.6%||6.7%|
|BofA Merrill Lynch Global High Yield Index||0.2%||0.9%||9.4%|
|JP Morgan EMBI Global Diversified Index||-0.4%||0.1%||9.1%|
|JP Morgan GBI-EM Global Diversified Index||0.0%||1.2%||16.1%|
|U.S. Dollar per British Pounds||-0.5%||5.0%||9.5%|
|U.S. Dollar per Euro||0.0%||0.7%||13.5%|
|U.S. Dollar per Japanese Yen||-0.8%||-1.7%||4.2%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.1%||-0.6%||-6.8%|
|FTSE EPRA/NAREIT North America Index||-2.3%||-0.4%||2.1%|
|FTSE EPRA/NAREIT Global Index||-1.3%||0.8%||11.4%|
|Bloomberg Commodity Index||-0.4%||0.3%||-2.4%|
|Gold (NYM $/ozt) Continuous Future||-2.1%||-1.9%||12.7%|
|Crude Oil (NYM $/bbl) Continuous Future||1.5%||7.3%||-5.7%|
Source: FactSet, Neuberger Berman.