European high yield portfolios dominated the 2017 top-ten best performing fixed income funds in Asia during 2017 according to sister publication Fund Selector Asia. The leader among the European high yield funds delivered a 21.4% return for the year.
These strong returns are not likely to be repeated in 2018, due to high valuations and the underlying risk created by the regulatory changes in Europe, said Gaud, speaking at a recent media event in Hong Kong.
Gaud is underweight European high yield bonds − a stance which has to do more with the returns of the asset class on a relative basis, rather than with the quality of the bond issuers, he explained.
European high yield bonds deliver lower yield than they should, he noted, as a result of recent high demand.
“The reason for it is regulatory change in Europe,” Gaud said. “Many insurers and banks have to purchase a large amount of bonds, regardless of price and return,” he noted. “60% of the European high yield bonds are priced below the US 10-year bonds. Some issuers [of European high yield bonds] still received six times oversubscription for bonds offering a real rate of return below zero.”
Some issuers therefore took advantage of the unhealthy situation to issue cheap bonds, even though their asset quality, while gradually improving, does not justify such low returns to investors, he added.
“Globally, those sectors and companies behind the [high yield bonds], such as energy firms, are in a better shape due to a rising oil price,” he said. “But do they deserve to issue bonds cheaper than US 10-year treasuries? Probably not,” he said.
Gaud said such “unhealthy and artificial” balance of demand and supply supports the European high yield bond market, but it might turn into a liquidity risk. “Although volatility sounds unusual in bond market, when it comes to crisis, it could be as big as on the equity side. [When] everybody runs for the exit, it could really hurt,” he noted.
Gaud would consider a re-entry into the European high yield only if there was a substantial correction.
On the flip-side, Gaud believes there are still some interesting opportunities in Asian bonds − both high yield and investment grade − since the yields remain reasonable and the local currency environment is favourable.
He noted that central banks in emerging markets still have room to lower rates, which would benefit emerging market bonds in general. “It is likely that the central banks in the emerging markets will cut rates further,” he said. “It is also possible to see a spread compression which would cause capital gain on the bond side,” he added.