Fixed IncomeMay 13 2013

Where next in the hunt for high yield?

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ByAmie Stow and Adam Eisenberg

The hunt for investment income continues and the conventional high-yield bond market is looking quite fully priced.

There are now no shortcuts for investors seeking higher returns in fixed-income markets. More substantial yields are only obtainable in exchange for giving up significant liquidity.

European high-yield bonds have delivered a 3.8 per cent return in 2013 so far – certainly the best return of fixed-income asset classes. Last year, price appreciation contributed roughly 60 per cent of global high-yield returns. But due to the amount of callable bonds, price appreciation is likely to play less of a part this year.

In the first quarter, 88 per cent of total return has come from the coupon. Spreads have widened slightly this year – after approaching their 2011 post-crisis lows – and are unlikely to narrow much further from here.

Given the current yield of 5.4 per cent on the European high-yield index, and allowing for likely credit losses, total returns in the region of 5-6 per cent in 2013 could be achieved.

This is still a better prospective return than we envisage from most other bonds. Indeed, high yield and emerging market bonds remain a favourite fixed-income asset class among strategic investors.

But the days of high yield delivering equity-like upside with credit downside are probably behind us, leading yield-seeking investors to look for new opportunities.

One possibility is to explore the private loan markets, which can offer commensurately higher returns on a risk-adjusted basis.

Lending to non-investment-grade companies has long been a key area of business for both European and US banks, but since the crisis there has been a massive retrenchment by traditional lenders as banks look to repair broken balance sheets.

US banks traditionally occupied roughly 40 per cent of the US private lending market with the remainder comprised of well-established non-bank lenders, which included speciality finance companies, collateralised loan obligations (CLOs), business development companies (BDCs), hedge funds, and private lending funds.

In Europe, such lending differs. There has been a larger historical ownership of the private lending market by banks – between 60 and 80 per cent – and Europe has neither BDCs, which exist exclusively in the US, nor sufficient CLO volume to pick up the slack.

As a consequence, there is a large prospective lending gap in Europe.

While fixed-rate investment-grade debt and, to a lesser extent, high yield, carries significant duration risk due to the inverse relationship between rates and prices, private loans typically move in step with interest rates, thereby protecting investors from the return erosion that would likely occur to fixed-rate securities should interest rates rise.