Exuberance for risky debt is moving toward Europe, and away from the U.S.
Junk bonds in the U.S. now offer investors the most extra yield relative to European ones on record, according to Bank of America Merrill Lynch index data.
The reason? Investors are attracted by the outlook for more stimulus from the European Central Bank (ECB)—which would support demand for risky assets in the region, just as the Federal Reserve prepares to raise interest rates in the U.S. after keeping them near zero since 2008.
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The question is whether Europe's most-indebted companies are really more likely to repay their obligations than their American counterparts given that the U.S. is forecast to grow almost three times as quickly as the euro region next year. The trend may be simply a case of investors chasing returns driven by easy-money policies instead of credit fundamentals.
"For a couple of years you've had technicals and central bank liquidity overwhelming fundamentals" across the globe, said Scott Service, a money manager for the $2.3 billion Loomis Sayles Global Bond Fund. Europe is "just a little behind in the credit cycle."
There are two main factors at work here. First of all, investors have been dumping U.S. junk bonds in the face of dropping oil prices, which have called into question the business models of energy companies that have sold record amounts of debt.
They pulled $1.89 billion from U.S. high-yield funds in the week ending Dec. 10, bringing outflows for the year to $16.4 billion, according to Lipper data. Meanwhile, plunging oil hasn't been as much of a deterrent for European junk-bond buyers because energy-company securities account for a smaller percentage of the market over there.
Second, bond buyers have also been less enamored of the U.S. market because the Fed's plans to tighten monetary policy may drive up their borrowing costs. They like the idea of the ECB initiating a bond-buying program, which analysts expect to begin next year and would probably push investors deeper down the credit spectrum searching for yield.
The result is an unprecedented divergence in compensation for owning junk-rated debt on both sides of the Atlantic. Investors are demanding 2.8 percentage points in additional yield to own the dollar-denominated notes compared with the euro-denominated ones, the most in data going back to 2004, Bank of America Merrill Lynch data show.
The spread has more than doubled from 1.3 percentage points as recently as June 27.
This doesn't completely make sense looking at the economic backdrop, which should support companies' ability to repay their debt. The U.S. will grow at a 3 percent rate next year, compared with a 1.1 percent expansion for the euro area, according to analysts surveyed by Bloomberg.
That said, it's paid to bet on central bank stimulus in recent years. The Fed's unprecedented accommodation fueled 18.6 percent annual returns on U.S. high-yield bonds in the five years through 2013, Bank of America Merrill Lynch index data show.
Bond buyers are now betting on a redux in Europe.
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