Last week, when looking at the the distortion and absurdity unleashed by the ECB's asset purchase program upon European capital markets, we showed the unprecedented collapse in European junk bond yields as captured by the effective yield of the BofA/ML Euro High Yield Index, which is now trading just shy of all time lows, having dropped below 3% at the end of April, and printed at 2.79% on May 23, within bps of record lows...
... roughly 50 bps wider than where the the US 10Y is trading at this moment, and inside the 30Y US Treasury. Assuming a 1.9% European CPI (as of April), this means that the real rate of return on Europe's junk yields is now 0.89%. But we digress.
So why does European junk debt trade with seemingly no more risk than the world's most risk-free security? Simple: expectations that the ECB will keep buying it, and so far it has. In fact, yesterday DB's Jim Reid reported that according to "the latest ECB CSPP numbers were out yesterday and I was surprised to see the average daily corporate purchases at €401mn last week, notably above the average daily run rate of €365mn since the program started. So back in April and early May it looked like a broadly equal CSPP/PSPP split but last week's numbers gives us the possibility that CSPP hasn't been tapered as much after all."
So much for the ECB tapering... and incidentally as of May 19, the ECB owned €86.9 billion in European corporate bonds, up €2 billion from the prior week, and lifting the number of securities held by the central bank to 924. Putting it in context, as of this weekend, the ECB held 13.4% of the entire €649.12BN in European corporate bonds outstanding.
Which brings us to an interesting observation from BofA's European credit analyst Ioannis Angelakis, who overnight writes that in Europe "Equities are the new "high" yield" as a result of the relentless collapse in junk bond yields. As the chart below shows, European equities are for the first time ever, offering higher yield than the HY Credit.
Here is the key section from Angelakis:
Despite long-term Bund yields moving higher in the past months, it seems that the front-end is still close to record levels. With front-end bunds at the lows, the problem of negative yielding assets has not really disappeared (chart 5). Notably more than 42% of the Euro-denominated fixed income market is still yielding below zero, hovering around that level since the start of the year.
Put that on top of (i) the short-duration the HY market exhibits (due to the high concentration of callable bonds) and (ii) the recent spread compression and one could see the HE00 index offering the lowest yield ever; below 2.8% (chart 6).
Angelakisdoes provide one possible explanation for the collapse in yields which is independent of the ECB's meddling: "we note the impact of the change in the composition of the market as a reason behind the low "yield" in the high yield market: the quality of our HY index has improved as BBs now constitute ~75% of the entire HY universe. Our view on European high yield for this year is that it will remain attractive to its investor base despite the tight valuations given strong technicals. This will push spreads tighter from here, and potentially yields even lower."
In light of this, is BofA's reco to short junk? Of course not: it would be sheer insanity to step in front of the relentless ECB juggernaut which continues to push yield chasers into the last remaining pockets of yield. Instead, he believes that even credit investors should start migrating to stocks - the last remaining bastion of yield in Europe. To wit:
Equity markets offer more attractive dividend yield, also exhibiting positive convexity on the earnings cycle.... While remaining constructive for high yield credit, as it offers better cushion to rising rates vs its IG counterpart, we think that European equities present a better upside opportunity. On a macro level investors could express this theme being long European stocks, while selling iBoxx € HY TRS as a RelVal trade, to reach "higher" yield.
Think about that for a second: the ECB has forced credit strategists to advise their credit-fund employed clients to buy stocks. Barnaby continues:
Debt investor's upside is always capped. After all, how much more than par plus the coupon can one make when you hold a fixed income instrument to maturity? As a debt investor's upside is capped, the asset is exhibiting negative convexity to the earnings cycle. On the contrary an equity investor is benefiting from the upside when the value of the company's assets increases. There is no cap on this optionality, as the equity performance should reflect the performance of the assets and the earnings outlook of the company. Thus an equity investor is long convexity.
For that reason one would expect that the equity market should out-perform on a bull market, but under-perform on downturns. Put another way, equities should be the "beta play" over the course of the business cycle. As chart 3 shows, this is exactly what investors have experienced in the US market. The draw-downs were more severe in the equity market, but bull markets were more rewarding. This has been the case over the past three cycles during which we have sufficient data to observe. However, we have not experienced exactly the same in Europe over the last cycle (chart 4). Even though equities have outperformed in the late 90s and the pre-GFC cycles, the trend has been the opposite since 2009.
What can possibly go wrong with this trade? All else equal, nothing... just assume the ECB will remain the buyer of first and last resort for the indefinite future. When that changes, please try to be the first to sell as suddenly the "market" will go from nearly offerless to bidless in milliseconds.