Credit Selectivity at the Fore in European High-Yield Bond Investing

Judiciousness and risk control have always been part of Oaktree’s investment approach, but current conditions highlight the importance of basing investment decisions on shrewd credit selection.

The threat of a no-deal Brexit also looms large over the UK economy and the Eurozone broadly. Add to this backdrop the fact that much of the European government an investment-grade bond market is now in negativeyielding territory. This has left investors with fewer attractive options in fixed income investing and driven the market further along the risk spectrum, resulting in a compression of spreads and limiting the income available to serve as a cushion to offset potential price declines. Investors face the challenge today of having to strike a balance between focusing on portfolio protection and finding investments that would provide a positive return. It is Oaktree’s view that such an environment calls for an increased emphasis on security selectivity. Judiciousness and risk control have always been part of Oaktree’s investment approach, but in light of the current conditions of the European high-yield bond market and reduced yields, we further stress the importance of basing investment decisions on shrewd credit selection.

Fundamental credit analysis: winning by not losing

Bottom-up fundamental credit analysis can allow an investor to more deeply understand individual investments. A thorough study of issuers and determinants of their credit quality serves as the basis for investors’ efforts to identify good and bad credits. We believe this affords investors a greater prospect of winning by not losing. “Avoid the losers, and the winners will take care of themselves” is a longstanding conviction of Oaktree’s and rings even truer today in the European high-yield bond market, where the cost of getting an investment wrong is high.

Today, we see elevated levels of underlying dispersion of single-name returns within high-yield bonds.1 With certain areas of the market plainly, if not dramatically, underperforming, we believe avoiding the losers is more important than identifying the winners (see table). Therein lies the opportunity for the skilled and discerning investor who has the capacity to engage in rigorous bottom-up analysis for each potential investment and is also able to avoid the flops.

We also consider fundamental credit analysis as one of the few things that can be known and practised consistently in fixedincome investing. This is in contrast to the many drivers of returns in credit investing that one simply cannot know or predict accurately, especially when it comes to components such as changes in benchmark interest rates and central bank policy decisions. In addition, specific to today’s low and negative-yield environment – “the bizzaro world of global debt”, as the Financial Times recently wrote – low yields and the promise of new liquidity have brought about “yield tourists”, who search outside of the typical investment turf to potentially capture extra returns.3 These dynamics have contributed to creating return anomalies and distorting market dynamics. Whilst an understanding of these dislocations is valuable, their evolutions are not predictable, which underscores the value of focusing on what is knowable rather than attempting to position investments around unknowable factors.

Flexible mandates: capitalising on the knowable

Whilst credit selection remains at the absolute core of Oaktree’s investing, we recognise that an understanding of closely related asset classes and of factors that drive dislocation adds another layer of opportunity. From this perspective, the latitude to cross the leveraged finance spectrum – covering both high-yield bonds and leveraged loans – can be a valuable asset. It can help investors capture greater returns, or add more protection or diversification features into a portfolio. The expanded range of options increases the scope to avoid losers, whilst preserving diversity.

The distinction between the two buckets of non-investment grade investing has blurred over time, more recently with a significant rise in covenant-lite loans and an increase in secured bonds shares in high-yield bonds.

Having purview over both opportunity sets not only affords investors a more diversified source of returns, but also allows them to tactically, and selectively, pivot across and within sectors to best capitalise on observable technical dislocations and relative value opportunities. For instance, whilst the spreads on European high-yield bonds and leveraged loans are largely correlated over the longer term, a closer observation of average spreads of similarly rated bonds and loans over the past several years reveals numerous pockets of substantial premiums and discounts that a well-resourced investor could have taken advantage of.

One driver of this anomaly: The make-up of the underlying buyer base of the two sectors is quite dissimilar. Retail mutual funds account for 35% of the high-yield bond investor base, whereas this buyer is largely absent from the loan market. This difference can affect capital flow dynamics particularly in volatile periods and help cause technically driven opportunities, something that investors with flexible mandates can take advantage of.

Amid risk and opportunity

Disciplined credit selection does not guarantee superior alpha in the short run, but we believe it is essential to achieving superior riskadjusted returns over the long run. We anticipate the variables that are at play today – loose credit conditions and weakening global economic health, among others – will continue to shift and present a mix of risk and opportunity. In this landscape, investors should heighten their focus on avoiding the losers, but also be alive to the opportunities that volatility and dislocation can present. European leveraged finance can offer the skilled manager differentiated return potential and serve as an attractive complement to other fixed-income investments.

Endnotes

* This article was originally published in CAMRADATA's October 2019 issue of Asset Focus. It is being posted with permission from CAMRADATA

¹ Barclays Credit Research European High Yield. 20 September 2019.
² Oaktree does not currently own any of these bonds. Oaktree had held the Astaldi bond in the past, which we sold in February 2014.
³ Negative bond yields spill into Europe’s emerging markets, 10 July 2019.
⁴ As of 31 August 2019. ICE BofAML Global Non-Financial High Yield European Issuers Ex-Russia 3% Constrained (EUR Hedged), Credit Suisse Western European Leveraged Loan Index.
⁵ As of 1 March 2019. Source: S&P LCD, EPFR, ECB, Bloomberg, Bloomberg Barclays Indices, Barclays Research.

ABOUT THE TEAM

Oaktree Capital Management is a leading global alternative investment management firm with expertise in credit strategies. Today, the firm operates in 18 cities and 13 countries and manages $120bn in assets, including $15bn in high yield bonds.

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