In the first quarter of 2012, the European secondary debt markets have outperformed those in the U.S. Starting with the more dramatic performance difference, European high-yield bonds gained 12.76% between January and March, more than double the 5.15% return for the U.S. comparable, based on the BAML European High-Yield Bond Index (HE00) and BAML High-Yield Bond Index (H0A0).

This is widest quarterly performance gap between the two indices in more than 10 years, since December 2001. The last time European high-yield bonds outperformed the U.S. was a year ago, although then the difference in return was just nine basis points.

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The performance so far this year of the U.S. and European leveraged loan secondary markets has been much closer in step, based on the S&P European Leveraged Loan Index (ELLI) and the S&P/LSTA Leveraged Loan Index. In the first quarter, European loans returned 4.36% (excluding currency), 60 bps ahead of their U.S. counterparts, at 3.76%. Similar to bonds, the last time the ELLI outperformed the S&P/LSTA Index was during the first-quarter rally of 2011.

Riskier deals lead

Dissecting the first-quarter performance, Europe itself was perceived as highly risky in late 2011, so had further to swing back this year when the macro environment improved. “In November and December the question was whether the euro would stay together, so Europe has come back off a lower base,” an investor said.

This effect was most strongly felt in the lower-rated and higher-yielding assets, which went on to drive-up first-quarter returns for both European high-yield bonds and leveraged loans.

Based on the HE00 index, notes rated CCC or lower gained a whopping 22.13% in the first-quarter rally, vastly outperforming the higher-rated buckets, where B-rated notes returned 13.21%, and BB notes 11.42%.

Of course, given the risky nature of the lower-rated paper, this sub-index not only made the largest gains during the rally, but also took the greatest hit during the slump of the third quarter.

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In the loan market, B-rated ELLI constituents posted the largest gains in the first quarter, moving up 4.52%, followed by the CCC-rated bucket, at 3.89%, while BBs underperformed, at 2.82%.

Supply thin in Europe

In terms of new supply that has catered to demand and kept the first-quarter rally in check, the U.S. primary leveraged finance market rebounded forcefully this year, whereas primary issuance in Europe remained light, thereby stimulating demand in the secondary market.

On the bond side, the U.S. saw a record-breaking first quarter, with €74.9 billion of volume. Europe’s activity was healthy, but at €12.2 billion it still fell short of the tally from the first quarter of 2011. Towards the end of the quarter, many accounts were on the secondary sidelines, feeling that prices were toppy and looking instead for new issuance to provide attractive paper.

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On the loan side, U.S. issuance roughly doubled from each of the prior two quarters and there was sufficient demand to allow a slew of opportunistic transactions, while European issuance saw little change and the pipeline remains thin in terms of new deals. Although there are some well-known auctions there is little in terms of imminent launches, so any proceeds from repayments could be looking for a home in the secondary market and supporting prices, sources said.

Chasing yield

The past 10 days has seen a resurgence of sovereign risk-related instability, which could lead to a retreat of risk appetite across Europe, but investors still talk of the underlying search for yield that will continue for as long as money managers can stomach the volatility.

On the high-yield front, U.S. senior unsecured new-issue bonds offered a yield of 7.08% (rolling 30-day average) at the end of March, compared with the 7.59% quarterly average yield for European senior unsecured new issuance. Sources suggest that a bout of volatility will lead to a period of greater differentiation in Europe, with weaker new issuance having to pay up, but a continuing strong bid for the better-rated credits.

Throughout the first quarter, investors have been creeping down into the BB space from investment grade, in the hunt for yield. “There is less conviction on equity by institutional pension fund money. For equity-type returns in a fixed-income product they have to go to non-investment grade – and that’s why the bid is there,” a source says.

These various factors have helped boost the average bid for European high-yield to a level well out of step with U.S. high-yield and loans in both regions, and leaves the average bid for European leveraged loans lagging behind.

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This scenario could potentially offer an opportunity for investors that are looking for senior secured paper with attractive yields, and that are comfortable with the numerous risks and idiosyncrasies of investing in European loans.

Indeed, some fund managers have noticed an improvement in the level of inquiry – particularly from consultants operating on behalf of pension and insurance funds. “There is more interest than there has been, although in measured terms. People are looking for yield and there is little out there,” says a manager. – Staff reports

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