Where do fixed income investors go from here?
As a global bond manager running many flexible mandates with the ability to invest across multiple (hard) currencies, we are constantly looking at relative value opportunities across geographies to find the best value for investors. One of the most frequent questions we have received of late is what we think about owning Europe (including the UK) versus the US.
With a gas situation in Europe that looks set to lead to (at least some) rationing through the winter, and the Bank of England predicting five quarters of negative growth in the UK, you could be mistaken for thinking the decision is easy. Well it would be, if on a currency hedged basis the yields were the same. If they were, then a strong allocation bias to the US would be the prudent strategy right now.
The contrasting economic environments either side of the Atlantic have driven some underperformance in European credit versus the US recently, but we do think these economies are more interlinked than the market is currently suggesting; both are consumer driven, and in both cases inflation is rampant with consumers getting squeezed rapidly and significantly. We have already had two quarters of negative growth in the US, and we’ve heard Fed members as recently as Thursday saying they do not think they will be able to bring inflation down without causing a recession (this is Minneapolis Fed president, Neel Kashkari, who has historically leaned dovish).
So for us, the Europe vs. US allocation decision as always comes down to a question of relative value on a currency hedged basis. Just for clarity, investing in euros and hedging to dollars now results in a pick-up of over 240bp.
Looking at relative value in the high yield markets, it is interesting that the historical relationship between Europe and the US has significantly unwound post-COVID. Between 2013 and 2021 European high yield had on average traded approximately 60bp tighter than US high yield (on an option adjusted spread basis), no doubt driven by the significantly supportive monetary policy environment in Europe, and of course the higher quality of the European high yield index which has significantly less low-rated oil and gas exposure.
Since the beginning of 2022, however, this relationship has reversed, with the European high yield index currently trading approximately 90bp wider than the US index. While some of this is related to the near term economic risks in Europe, it is worth noting that the European high yield index is both better rated (BB- vs. B+ in the US) and shorter (credit spread duration of 3.4 years vs. 4.1 years), with a yield-to-worst of almost 8.5% in dollars vs. 7.4% for its US counterpart. European high yield has also historically had a much lower default rate (1.8% vs. 3.5% in the US).
So the Europe vs. US allocation debate is a lot more complex than a fundamental geographic view of the respective economies.
Ultimately, there will be good bottom-up opportunities in both geographies given yields are significantly higher than the longer term average. But the question of geographic allocation for a currency hedged investor has to come down to relative value, and there is no doubt we are seeing attractive opportunities in Europe as well.
As always, your top-down allocation has to be met with rigorous bottom-up credit selection, so for us that has meant minimising exposure to energy intensive sectors like chemicals and paper and packaging, and of course focusing on businesses that have strong pricing power.