European high yield: We need to talk about Sharpe ratios

November 27, 2024

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Investors considering an allocation to European high yield should pay heed to the old adage that time in the market is a more prudent approach than trying to perfectly time their entry, argues Thomas Samson.

"When is the right time to make an allocation into European high yield?"

This is a question I have been asked many times by clients, not unsurprisingly given the asset class has a somewhat misguided reputation for being risky and more volatile than most.

My response has been to highlight the behaviour and returns of the asset class over time in the context of its sub-asset class peers and European equities, to which it is commonly compared. Several themes stand out, which together demonstrate that time in the market is preferable to market timing, as coupon payments make the most of the return. 

Comparable returns to equities with less volatility 

Over 20 years, European high yield has delivered returns close to the annualized returns of European equities with less than a third of the volatility. Compared to European investment grade, annualized returns were more than twice as high, albeit with higher volatility, as you would expect.

Figure 1: 20-year risk/return of European high yield versus other asset classes

Past performance is not a reliable indicator of current or future results.

Index performance is for illustrative purposes only. You cannot invest directly in the index.

Source: ICE Data Platform and Bloomberg, as of October 31, 2024. Data covers the period December 31, 2004 –October 31, 2024. European equity: STOXX Europe 600 (Gross Return) EUR (SXXGR Index), EURIG: ICE BofA Euro Corporate Index (ER00), European HY: ICE BofA Euro High Yield Constrained Index (HEC0), German 7-10 year: ICE BofA 7-10 Year German Government Index (G4D0), German T Bills: ICE BofA 3-Month German Treasury Bill Index (G3DB). For illustrative purposes only.

Quantitative easing distorted risk/reward, but volatility remained below equities

Over the past decade, the European Central Bank’s quantitative easing policies created a large pool of negative-yielding assets that distorted risk/reward valuations in every asset class.  This anomaly also meaningfully lowered returns for fixed-income investors, including in high yield. During this period, European high yield delivered about half the returns of European equities, but with around a quarter of the annualized volatility.

Figure 3: 10-year risk/return

Past performance is not a reliable indicator of current or future results.

Index performance is for illustrative purposes only. You cannot invest directly in the index.

Source: ICE Data Platform and Bloomberg, as of 31st October 2024. Data covers the period 31st December 2014 – 31st October 2024. European equity: STOXX Europe 600 (Gross Return) EUR (SXXGR Index), EURIG: ICE BofA Euro Corporate Index (ER00), European HY: ICE BofA Euro High Yield Constrained Index (HEC0), German 7-10 year: ICE BofA 7-10 Year German Government Index (G4D0), German T Bills: ICE BofA 3-Month German Treasury Bill Index (G3DB). For illustrative purposes only.

Best Sharpe ratio

Over both 10 and 20-year periods, however, European high yield has generated the best Sharpe ratio – a measure of returns relative to risk - of all five asset classes. Looking ahead, we expect coupon clipping to be the biggest driver of returns for high yield; therefore, time in the market will matter more than market timing.

Figure 5: Highest Sharpe ratio

Source: ICE Data Platform and Bloomberg, as of 31st October 2024. Data covers the period 31st December 2004 – 31st October 2024. European equity: STOXX Europe 600 (Gross Return) EUR (SXXGR Index), EURIG: ICE BofA Euro Corporate Index (ER00), European HY: ICE BofA Euro High Yield Constrained Index (HEC0), German 7-10 year: ICE BofA 7-10 Year German Government Index (G4D0), German T Bills: ICE BofA 3-Month German Treasury Bill Index (G3DB). For illustrative purposes only.

In summary

Over a 20-year period, the European high-yield market has demonstrated strong performance, with returns close to equities but with less than a third of the volatility.

On a risk-adjusted basis, it has also delivered the highest Sharpe ratio across asset classes to which it is commonly compared (as demonstrated), while experiencing lower drawdowns and a faster recovery than equities after episodes of financial stress.

In our opinion, for income-seeking investors, European high-yield could be an attractive long-term strategic allocation, with future returns likely to be driven mainly by coupon payments. This supports the argument for a ‘time in the market’ approach rather than trying to find the perfect entry point.

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of November 2024 and may change without notice.

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