Europe offers alternative to frothy US high-yield market

Wed Mar 6, 2013 12:36pm EST

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NEW YORK, March 6 (IFR) - Investors looking to escape the current frothiness in the US high-yield market should look for better returns in Europe, where there is still some value on offer despite the prevailing political and economic risks.

"The nascent recovery in the US will continue to support a great rotation into equities, whereas low growth and low inflation mean credit is still the sweet spot in Europe," said Alberto Gallo, head of European Macro Credit research at RBS in a recent report.

Low valuations, the use of leverage for M&A and LBO activity, and the re-emergence of risky instruments like PIKs and covenant-lite bonds are all clear signs that US credit is overvalued and approaching bubble-like conditions, said Gallo.

"In Europe, credit remains attractive, as valuations offer more."

European high-yield bonds trade wider than their US counterparts despite fewer defaults, better average ratings, a lower risk of rising rates and still-strong technicals.

"We remain long credit and long high-yield, although hedging instability in Italy and Spain," he said.

The European high-yield market has grown by over 150 percent over the past five years - a growth rate faster than anything in the history of the European or US markets, according to Andrew Sheets, head of European credit strategy at Morgan Stanley.

"Oddly, this growth happened despite widespread economic deleveraging and a marked improvement in market credit quality," Sheets says.

UK-based Morgan Stanley strategists continue to have a modest overweight on European high-yield, both outright and relative to the US high-yield market.

"We think credit in Europe will post stronger total returns than the US in 2013, in part due to a weaker economic environment supporting lower rates," says Sheets.

Meanwhile, European Double B bonds look particularly cheap on a spread basis versus their US counterparts.

"On a relative value basis, it's also more of a question about how you view the economies of each region," says Andrew Lake, head of high-yield at Mirabaud Asset Management.

"Double Bs in the US are trading very tight, and are therefore more vulnerable to a move wider in US Treasuries, while in Europe, we are still mired in recession and are perhaps less at risk from rising rates."

The different economic outlooks have also prompted some investors to distinguish between cyclicals and non-cyclicals.

"In the US, cyclicals should do better," Lake says. "Even Triple Cs could do well in a stronger environment. The next opportunity in Europe will be spotting when the economy starts to turn."

But as long as Europe's economy continues to teeter on the edge of recession, and sovereign-led systemic risk dominates the headlines, the European high-yield market will still be a risk too far for some.

"The European speculative-grade market is less liquid and prone to more volatility than the US market," said one investor. "I'm not sure we would be in the camp of buying in this market."

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