Fixed IncomeOct 30 2013

Natural shift to a more balanced market

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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.

European market participants increasingly view high yield as a well-established asset class. It has become an integral part of many institutional investors’ strategic allocations to fixed income. As the market is maturing, it is transforming into a fully-fledged component of the global fixed income universe and its diversification and liquidity have improved.

Consequently it has become an increasingly attractive option for income-seeking investors from around the globe and the likely target of new capital inflows from global fixed-income funds.

Historically investors have viewed high yield as part of a fixed-income allocation, but in reality the behaviour of high-yield bonds has not followed other fixed-income sectors as closely as you might imagine.

Based on statistics provided by Bank of America Merrill Lynch Global Research, looking back at three decades the correlation of high-yield bonds with investment-grade bonds has been surprisingly low at just 0.3. By comparison the correlation with US stocks has been 0.56 so it turns out that, historically, high-yield bonds have tracked stocks more closely than they have tracked apparently more comparable investment-grade bonds.

The returns of high-yield corporate bonds, such as equities, are strongly linked to the business results and fundamentals of the underlying companies. High-yield bonds tend to outperform investment-grade bonds when interest rates rise because interest rates usually rise when business conditions are strong – in fact they are typically insensitive to interest rate movements.

Indeed US high-yield bonds have a negative correlation with 10-year US Treasuries in the long term, again based on BofAML Global Research’s analysis.

The same research shows that, from a volatility perspective, high-yield assets have shown half as much volatility as equities while being fundamentally less risky because bondholders get paid before shareholders if the company declares bankruptcy.

Of course this does not mean that the asset class is immune from bouts of volatility and illiquidity. Markets become dislocated in times of fear or panic and investors need to be prepared for the impact of mark-to-market risk on their capital values.

Transacting during periods of market stress can be very difficult and the general rule of thumb is that you should only buy bonds that you are happy to hold through an effective market shutdown. The ability to take a long-term view is essential.

Many high-yield investors are interested not only in attractive yields, but also in the potential for capital gain that can result from positive credit events. Indeed ‘event-driven’ credit investing has one of the best risk/return profiles for the medium to long term. Such managers invest in the debt of companies where there is a high probability of a positive credit event occurring that triggers a re-rating or a refinancing of the debt, providing a capital gain. While waiting for the event, they collect an attractive running yield from the coupon payments.

One of the great advantages of this approach is that an event-driven high-yield manager is not trying to predict the direction of the stock market, the economy, interest rates or elections, so is not reliant on picking that opportune moment to invest. The ability to understand industry and company-specific fundamentals as well as the technicalities of bond-specific terms is critical. A successful outcome usually requires patience and an unwavering focus on achieving a clear exit. As Benjamin Benjamin Franklin said: “Diligence is the mother of good luck.”

The key risk is clearly default and therefore companies that exhibit poor management, poor industry fundamentals, disadvantageous competitive positioning or poor financial controls need to be avoided. This is where the destructive nature of asymmetry in this asset class is at its worst.

Although we have witnessed a relentless fall in yields in the past five years since the depths of the credit crisis, we believe that many value opportunities remain in the European high-yield market and particularly in event-driven and special situations credit investing.

Refinancing deals are being completed and the transition from loan to bond financing continues. This, combined with the initial public offerings market heating up, provides exit events for sponsors and catalysts for the re-rating of corporate credit.

Furthermore we are now witnessing the early signs of recovery in Europe which provides a very supportive backdrop for high-yield credit investors – there are more opportunities because of greater number of corporate credit events, combined with fundamental credit improvement. Signs of the recovery can be seen in the graph, sourced from Bloomberg, which shows the progression of the European Purchasing Managers’ Index for the past two quarters:

Fundamentally credit metrics remain solid and, in fact, better than during the previous cycle, and I believe that the single B and CCC rating buckets represent the best risk-adjusted return potential compared to other areas of high yield or investment grade, which are susceptible to duration and interest rate moves. Credit spreads are still pricing in default risk in excess of historical averages and are still substantially wider than before the crisis in 2007.

The record growth in high-yield issuance is providing numerous investment opportunities in both the primary and secondary bond markets. The high-yield market has grown approximately 10-fold since 2001, continues to experience healthy inflows and is expected to grow strongly as more corporates and sponsors access this form of financing compared to loans.

Accordingly I believe that the European high-yield corporate debt market still offers attractive risk-adjusted returns as opposed to other asset classes given the backdrop of low global growth, low interest rates and the gradual withdrawal of central bank liquidity in the coming years. The market environment is well suited to the stockpicking-style investor who has a nimble and adaptive strategy and can access a wide range of opportunities.

John Sullivan is credit fund manager for City Financial Investment Company

Key points

Sub-investment grade credit is traditionally known as junk to its detractors and as high yield to its buyers.

The returns on high-yield corporate bonds, such as equities, are strongly linked to the business results and fundamentals of the underlying companies.

We are now witnessing the early signs of recovery in Europe which provides a very supportive backdrop for high-yield credit investors.