2021 Investment Themes: Opportunities in the Dawn of a New Cycle
PGIM asset managers share key investment themes likely to drive markets in 2021 and strategies for investors to capitalize on the opportunities they may bring.
In a region inundated with negative-yielding government debt and an uncertain growth outlook, European investors face the challenge of generating positive real returns in the coming years. Yet, that backdrop is suited to the following factors within the European high yield market:
During the height of the virus-induced selloff, these factors contributed to less spread widening relative to the U.S. high yield market (hedged to euros for comparison purposes) and to 2010’s volatility during the sovereign-debt crisis (Figure 1). They also contributed to the sector’s relative underperformance during the recent risk rally, which still occurred in an environment where the virus-related effects on certain credits and industries may be permanent.1 Therefore, the five factors in the European high yield market culminate with the importance of accurately selecting credits that can contribute to attractive risk-adjusted returns going forward.
European corporate bonds have historically experienced relatively low default rates, and we expect that trend to continue in the coming years. The 12-month default rate in European and U.S. high yield ended October at about 4% and 8%, respectively (Figure 2), and over the next 12 months, we expect half of that pace in Europe and a pace of about 6% in the U.S.
Beyond 12 months, it’s possible European defaults could tick slightly higher while the U.S. rate continues to decline. Yet, our base case—bolstered by a recent bottom-up default analysis across the sector—sees European defaults remaining well below 3% over the next 24 months, particularly given that the refinancing requirements for most European issuers do not increase until 2023, thus providing additional time for a euro area economic recovery to take hold.
The stark difference in U.S. and European default rates is partially driven by the European market’s limited exposure to highly-cyclical industries, such as energy, gaming, lodging, and leisure, that account for more than 55% of U.S. high yield defaults in 2020.2 As we note below, the structure of Europe’s stimulus efforts have also mitigated default activity.
Given the recent and expected default activity, it follows that the European market is comprised of higher-rated high-yield credits with 69% of issuers rated BB vs. 45% in the U.S. market. Stronger fundamentals, such as lower average leverage and higher interest coverage ratios, support the credit quality of the European market, while at the other end of the ratings spectrum, 8% of the Euro high yield market is rated CCC and below, compared to 17% of the U.S. high yield market (Figure 3).
In many ways, European stimulus measures have been greater than those in the U.S. and have helped many European credit issuers weather the pandemic with limited deterioration in fundamentals thus far.
For example, the ECB’s €1.35 trillion Pandemic Emergency Purchase Program’s purchasing power is the equivalent of approximately 7% of outstanding euro-denominated debt, considerably higher than the Federal Reserve’s soon-to-be shuttered $750 billion program that amounted to 2% of outstanding USD-denominated debt.3 The ECB’s support drove notable richening in eligible investment grade bonds, leading to increased interest in European high-yield assets.
On the fiscal side, the European Commission’s stimulus includes €1.29 trillion in emergency funding to help repair the economic and social damage from the virus. In addition to loans for small and medium enterprises, the 3% limit on fiscal budget imbalances has been suspended for the next two years. This flexibility has allowed many European countries to adopt measures supportive of the broader population, including furlough schemes that fund 60-80% of worker salaries for up to two years. Meanwhile, another tranche of U.S. fiscal stimulus has been slow to emerge.
Despite the recent, promising vaccine news, many companies still need to make it through the uptick in case counts, past the targeted restrictions, and to a point where economies are more fully open. Although COVID-sensitive sectors, such as energy, airlines, and retail, rebounded strongly in November, the pandemic likely left them with long-term, if not permanent, effects. And the European high yield market has relatively low exposure to many of the most severely impacted industries as energy, airlines, leisure, metals, gaming and retailers account for less than 10% of the market while these same sectors account for about 25% of the U.S. high yield market (Figure 4).
European investors face the daunting prospect of generating positive real returns in the coming years. Low to negative government rates amid an unclear—but likely subdued economic backdrop—pose sizable hurdles. Yet, the prior four points culminate in an environment that underscores the need for thorough financial analysis, scenario analysis, and stress testing. This analysis was part of our recent bottom-up analysis that indicated defaults across the European high yield sector would be lower than the consensus view, thus creating the opportunity to identify credits and industries that would not only withstand the ongoing financial strain, but would also emerge as holdings capable of contributing to positive real returns in the years ahead.
This material reflects the views of the authors as of December 9, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1 In the second half of 2020 through November 30, the European high yield market underperformed the U.S. high yield market (hedged to euros) by 110 bps.
2 Source: JP Morgan as of September 30, 2020.
3 Source: ECB, Federal Reserve and BIS.
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1043445-00001-00 Ed: 12/2020
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