Those yields sure are low in the European market

August 23, 2019 — In this Q&A, the Eaton Vance floating-rate loan team offers its perspective on today’s loan market.

By: Craig P. Russ; Andrew Sveen, CFA; Ralph Hinckley, CFA; Christopher Remington

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By Jeffrey D. MuellerPortfolio Manager, High Yield Team and Justin H. Bourgette, CFAPortfolio Manager, Global Income Team

London and Boston - The Multi-Asset Credit team here at Eaton Vance has an axe to grind. It feels like almost every day we see another U.S. commentator talking the European credit markets down, with rhetoric along the lines of:

1. "Those yields are just so low ..."

2. "I can't get excited by high-yield bonds paying a coupon of around 3% ..."

We take issue with what we see as lazy commentary.

Let's focus on high-yield corporate bond markets initially, one of the key markets that the Multi-Asset Credit team typically invests in. The headline yield on the U.S. high-yield corporate bond market (all U.S. dollar denominated) is substantially higher than that of European market (euro and sterling denominated). The table below shows the headline yields in local currency terms:

Blog Image Global High Yield 1 April 9

That settles that argument then. Yields are lower in Europe, so just ignore the European markets and focus on the U.S. markets.

Introducing the power of currency hedging

Not so fast, readers, not so fast. Enter the power of currency hedging. Can we buy European assets and hedge that currency risk back to U.S. dollars? Of course we can. The market for currency hedging contracts is one of the largest and historically most liquid out there.1

What happens if we buy bonds denominated in European currencies and hedge them back to U.S. dollars?

Because of the large differential in the level of base interest rates in the U.S. versus the U.K. and the Eurozone, the lower headline yields in Europe immediately look more attractive when hedged back to U.S. dollars. Expanding on our examples above to create a like-for-like comparison shows a completely different picture altogether:

Blog Image Global High Yield 2 April 9

You can see that, on a hedged basis, the yields are actually higher in European markets than they are in U.S. markets.

What's more, hedging the currency risk of non U.S. dollar assets allows investors to potentially avoid any unwanted fluctuations in the foreign exchange markets. We just need to look at the outsized movements in sterling since the U.K. voted to leave the European Union for evidence of the volatility that can exist. This means that credit risk is going to be the primary driver of returns, and analysing credit risk is something we think we're good at here at Eaton Vance.

Of course, currency hedging can be complex and costly for individual investors, so it is important to understand the risks involved along with the potential benefits.

Dismissing an entire continent because of low headline yields is very lazy analysis

We've established that like-for-like yields are actually not more attractive in the U.S. at an index level, but what about looking at a specific example?

For global investors, one of the big opportunities that often presents itself is the dislocation between bonds issued by the same company, but in different currencies. The demand for U.S. dollar denominated bonds is often higher, leading to lower prospective returns (i.e., lower credit spreads and lower yields) due to a couple of key factors:

  • Perceived liquidity constraints
  • A U.S. investor base that typically focuses more on domestic U.S. opportunities, and a European investor base that typically focuses more on domestic European opportunities

For example, a U.S. company has a 4.625% euro denominated bond and a 6.375% dollar denominated bond in issuance, both with the same maturity date (July 2026). For the same credit risk, investors in the euro denominated bond can earn 0.4% of extra credit spread per year (data from Bloomberg, as of March 31, 2019).

For an investor with the ability to hedge the currency risk, a decision can be made solely on the basis of credit risk. Assuming the company does not default, buying the euro denominated bond and hedging the currency risk may lead to a higher total return than the dollar denominated bond, with no increase in credit risk.

Bottom line: We believe it makes sense to look past the low headline yields in Europe and pay attention to potential investment opportunities. We are advocates of taking a global approach to investment markets. We believe there are opportunities for U.S. dollar based investors to look at income markets on a more global basis, including the ability to hedge unwanted currency and potentially boosting yield.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.