European junk bonds hit a sweet spot Record issuance levels and a wall of money rushing into European high-yield bonds have raised questions about the sustainability of the current market. More than $46bn of euro-denominated high-yield bonds - also labelled "sub investment grade" or "junk" - have already been issued this year. This is 50 per cent more than in the whole of 2012, and almost double the amount issued by the same stage last year, according to Dealogic. Christine Johnson, London-based head of fixed income at Old Mutual's corporate bond fund, says that three months ago, bond investors were very cautious for a variety of reasons: the prospect of higher interest rates, raised by Ben Bernanke's talk of tapering quantitative easing; concerns over Syria; the Italian election; and a possible US showdown over debt. "As these concerns have receded, there is suddenly a huge weight of money being passed into the high-yield market," she says. EPFR, the fund data provider, confirms there was a surge of money into European high-yield credit funds after the US crisis was allayed, and estimates that so far this year, cumulative inflows exceed $17bn for high-yield and $27bn for European equities. "Europe is in a sweet spot," says Ms Johnson. "Growth is flat, or only gradually recovering, so there is a "lower for longer" feeling about interest rates. Where is the place in the world where you least expect interest rates to rise? It has got to be Europe. The high-yield market is also being driven by more fundamental shifts, such as the need for European corporates to tap the bond markets for finance as capital-constrained banks shrink their balance sheets by refusing to renew loans to traditional customers. Fraser Lundie, of Hermes Credit's global high-yield bond fund, says 33 per cent of European high-yield bonds have come over the past year from companies that were first-time issuers, whereas in the US the comparable figure was 5 per cent. "It shows you where the US market is, and where the European market is going," he says. Mitch Reznick, head of credit research at Hermes Credit, says that the size of the European high-yield sector has trebled since 2008 and is no longer dominated by telecom groups. The sector has also been boosted by "fallen angels" - companies that have slipped below investment grade - and a recent influx of small companies. Increasingly, corporates are borrowing more, for longer and cheaper, which can often mean poor value for the bond investor on the other side of that trade Paul Smith, corporate bond fund manager at Premier Asset Management Moody's, the rating agency, says there has also been a flurry of small companies issuing high-yield bonds for the first time, with six companies, each with core annual earnings (earnings before interest, tax, depreciation and amortisation) of less than $50m, raising a total of about $2bn. Moody's adds: "It is encouraging to see the success of these small companies in issuing bonds at the bottom of the ratings spectrum. However, it remains to be seen if this is a temporary consequence of investors" search for yield, that will diminish as interest rates rise." Paul Smith, corporate bond fund manager at Premier Asset Management, believes that in the near term, the Fed's delaying of tapering and general loose monetary policy supports the current strong demand for risky assets as investors hunt for yield. "For corporate issuers this can be an opportunity to lock in fixed-rate, long-term capital before rates start to rise," he says. Increasingly, corporates are borrowing more, for longer and cheaper, which can often mean poor value for the bond investor on the other side of that trade, although defaults will remain low for the near-term. Ms Johnson sees potential dangers in bonds rated BB or Ba1 - the top end of the high-yield market. BB looks overbought, since it has been backed by investors who are not really high-yield people, and could exit quickly. But single B and CCC bonds still offer 9 per cent yields. You've got to do your homework, but selectively there are still good opportunities. At Hermes, Mr Lundie argues that any shift in sentiment that spooks investors in BB-rated bonds will also hit lower-rated issues. Part of his strategy is to focus on bonds that have been issued in the past 12 months and now trade below face value. He says: "High-yield bonds usually offer change-of-control put options that allow investors to redeem at more than face value. This "optionality" further improves the potential for returns from investing in bonds below face value." However, Mr Smith believes a stronger growth outlook indicates an improving fundamental picture that will continue to support positive excess returns for European high yield. "Demand for the asset class has been increasingly driven by retail, which has been the fastest growing part of the high yield buyer base, with significant growth in European high-yield ETFs [exchange traded funds] and mutual funds," he says. A greater weighting towards Europe in global funds and consistent inflows for dedicated European funds all serve to boost demand.