As advisers will be well aware, the vast central bank asset-purchase programmes of recent years have resulted in compressed yields on government bonds and investment-grade credits.
This in turn has prompted many investors and asset allocators to take on more credit risk through increased exposure to high-yield bonds. This asset class has also benefited from more favourable economic data over the past 12 months and, more recently, greater comfort among investors with the implementation of tapering.
Against this backdrop, issuance of high-yield bonds has reached record levels. Over the past two years, US issuance has been running at more than $300bn (£175bn), inevitably stoking fears of a bubble in the asset class. While undoubtedly there have been many new companies coming to the debt markets to raise capital against a backdrop of constrained bank lending, it is important to bear in mind that the majority of new issuance relates to refinancing of existing debt, while the cost of capital remains historically low. This in turn has pushed out refinancing risk to 2018 and beyond – historically a leading cause of default (albeit at the same time reducing the coupons on offer).
Historically too, high-yield bond default rates tend to be correlated with global growth. Assuming a backdrop of low, albeit positive, real growth continues, we would therefore expect default rates to remain low since activity would not be weak enough to raise the risks of balance sheet and /or operating issues.
While credit quality on new high-yield bond issuance has clearly been deteriorating in recent years, this has been from a reasonably strong base and is partly a reflection of investor demand for the asset class and the ongoing search for yield. Examples of this include higher leverage (debt to earnings before interest, taxes, depreciation and amortisation), increasing use of payment-in-kind structures and weaker call protection (limiting upside for investors). That said, leverage ratios remain in line with historical averages and interest coverage (ebitda/net interest) remains high. Although yields are at record lows, spreads nevertheless remain above the lows recorded in the mid-1990s and 2000s, while the default outlook remains benign. However, further price appreciation is likely to be constrained by call structures built into corporate bond covenants.
Yields in Europe are lower relative to those in the US, reflecting lower sovereign bond yields and a higher-quality universe. Spread levels, once accounting for difference in the quality of the US versus European high-yield bond indices, are not that dissimilar. On balance, the US might offer a marginal relative value advantage given the stronger macro environment and increased drive for yield already recognised in the euro area after recent central bank intervention.
Since the 2008/2009 financial crisis dealer inventory levels have collapsed. As a consequence, market liquidity is poor and more correlated with market direction. Given this backdrop, prices in the asset class run a greater risk of heightened volatility at times of investor redemptions. The European high-yield bond market has seen increasing issuance in recent years as more companies in the eurozone turn to the bond markets as opposed to banks to raise capital. However, this market remains small compared with that in the US. I expect the European market to remain more illiquid and more of a beta play relative to the US and therefore more likely to suffer greater losses if a liquidity-driven event were to occur.
Stagflation or deflation could potentially be a risk for high-yield bond markets. At present, this risk would seem to be more focused on eurozone markets. Another possible risk is a normalisation in yield curves, which could result in a back-up in spreads – arguably this is more relevant to the US market.
Liquidity-related price volatility in credit markets could be a further risk factor, although it remains to be seen to what extent broader equity markets remain unaffected by such a scenario.
I believe interest rate movement will be the key performance determinant in the coming years, as opposed to the emergence of any credit issues. In my opinion, company fundamentals remain strong, defaults will remain low and interest rate coverage high due to the low cost of debt refinancing. The more likely scenario is for rates to remain low and/or increase steadily. However, it is the market reaction to such a backdrop that is key, in particular perceptions on how fast and far rates might move. As a result, we would expect to see increased volatility around data releases from the US Federal Reserve and other central bank statements. This could create buying opportunities, given that the investor base is already long credit. Consequently, it may be prudent to retain some portfolio liquidity against any allocation to the asset class.
In summary, it is important to manage investor return expectations for high-yield bonds. The upside for credit to perform on a total return basis is limited, in my view, and strong nominal and real returns from this point are arguably unlikely in anything other than a 1990s Japan-style scenario. However, while it is less attractive than in previous years, I do not consider the high-yield bond market to be in bubble territory. It would, however, be prudent to hold back some liquidity to take advantage of any pullback in prices, focus more on US high-yield bonds and resist the temptation to over-reach for yield in more illiquid markets at this stage of the cycle.
Gareth Lewis is chief investment officer of Bestinvest
Many investors and asset allocators have taken on more credit risk through increased exposure to high-yield bonds
Credit quality on new high-yield bond issuance has clearly been deteriorating in recent years
Yields in Europe are lower relative to the US, reflecting lower sovereign bond yields and a higher-quality universe
