Fixed Income  

Natural shift to a more balanced market

This article is part of
Searching for income - October 2013

The growing cohort of income-seeking investors can be forgiven for being attracted to the attributes of this asset class while being reticent when faced with its risks.

When you think more carefully about this, neither term is particularly appropriate these days. High yield? Yields have broadly fallen to historically low levels, particularly in the US. Junk? Many of the underlying companies are world leaders but have a non-investment grade rating from Moody’s and Fitch Ratings, primarily due to the leverage on their balance sheets

Being able to determine the differences between sustainable businesses with low, or no, credit ratings; businesses that are flawed but can be restructured and firms that genuinely merit the junk label, is absolutely critical. But the correct analysis of these opportunities can be rewarding not only in terms of enjoying high levels of running yields, but also in the potential for capital growth.

High yield emerged as an asset class in the US in the late 1970s. Other US innovations during this period, such as Post-it notes and disco music, immediately took the world by storm but it took 20 years for high yield to cross ‘the Pond’.

European companies relied on bank loans rather than capital markets for their funding needs. The game changer was the advent of the euro which accelerated the growth of a fledgling market that had begun to emerge in the late 1990s. The European high-yield market has been growing at a faster pace relative to its US counterpart since 2002 when the euro was fully implemented and issuance levels have taken off in the past couple of years with nearly $60bn (£37bn) issued last year, based on data produced by Merrill Lynch Global Research.

The financial turmoil of 2008 triggered a fundamental shift in the European credit market landscape.

Previously bank loans had been available to most companies on borrower-friendly terms. However, as banks found themselves at the epicentre of the credit crisis, they were forced to curb lending and to focus on repairing their balance sheets.

Bank lending to corporates shrank dramatically and companies had to look towards the capital markets and start issuing public debt in the form of high-yield notes. This coincided with a surge in demand from investors looking for yield and adding risk to their portfolios.

Basel III rules have set new and more stringent standards for banks in terms of their capital adequacy and liquidity ratios which will prevent bank lending in Europe from returning to pre-2008 levels.

We are seeing a major structural change in the capital structures of lower-rated European companies, bringing them into closer alignment with their US counterparts as their bank loans are replaced with public debt. It is part of a natural shift to a more balanced loan and bond market which already exists in the US. The European high-yield market has doubled in size since 2009 and looks set to double again in the next few years to reach $600bn (£370bn) by 2015.