Getting the call on a company’s fundamentals and its default risk right, is a key part of managing a high-yield bond portfolio. It is also a major performance driver. However, there are other factors that can add value to a portfolio. One of them is exploiting pricing discrepancies of similar bonds that are denominated in different currencies.
Generally speaking, the European and US high-yield markets move broadly in tandem most of the time. That is despite them having vastly different sector allocations – the energy sector in the US is significantly larger, for example – and different rating weightings, with a much lower proportion of CCC’s in Europe. However, the European market is less liquid, due to its smaller overall size and smaller individual issues, and it is, in our opinion, also less efficient. This often leads to real valuation gaps that can be exploited by nimble investors who follow both markets closely. For example, the credit spread on European high-yield bonds is currently almost 100 basis points (bps) higher compared to their US peers, despite the former’s better average rating and lower duration (measured by the regional index components of the ICE BofAML Global High Yield Index).
One reason why we like to focus particularly closely on companies that issue in both US dollars and euros with similar profiles in terms of rankings, maturities, etc. is so that we can take advantage of these pricing differentials. Since May, the price differential for numerous credits has widened significantly. Although that gap can widen further still, it must ultimately close, as both bonds will be repaid (or default and then trade to a similar level). Using index pricing as of August 17, Carnival Cruise Lines unsecured 2026 bonds (exact same coupon and maturity date) trade at an option-adjusted spread (OAS) of 1151 bps in euros, compared to just 820 bps in USD. The euro bonds even have a lower cash price so that they are worth a bit more. We believe that if you have a positive view on a credit and you get paid a premium of 330 bps simply because it is issued in a different currency, then it is an easy decision in which one to invest.
Over the medium term, this can be an attractive way to enhance returns without increasing risk. It is important to note that by hedging currency exposures, one can profit purely from these pricing discrepancies without incurring any additional currency risk. Similar cases exist in issuers such as Teva (211 bps pick-up in euros with one year longer maturity but lower cash price) and Primo Water (233 bps pick-up in euros with 6-month shorter maturity and lower price). Of course, it is essential to do the fundamental credit work to ensure, as far as possible, that the credit will not default, and to be aware that those spread differentials could potentially widen further in the short term. As an example, when the Teva bonds were issued in November 2021, the difference was only around 95 bps. Investors must have the tolerance to ride out the greater volatility in the European high yield market caused by the lower liquidity and greater inefficiency. However, assuming this to be the case, investing in euro-denominated securities of similar securities to their USD counterparts is perhaps one of the closest things to a ‘free lunch’ that credit markets offer.