Fixed Income  

Shaken, not stirred

Shaken, not stirred

Junk bond funds in Europe are attracting record inflows after the European Central Bank’s ‘big bazooka’ programme to stimulate the economy was announced.

The €1trillion bond buying plan will inject €60bn (£43bn) a month into European markets until September 2016. With government and other investment-grade yields being suppressed as a result, investors searching for yield continue to turn to other asset classes, including junk bonds. According to figures from Bloomberg, investors poured more than £233m into the iShares Euro Yield Corporate Bond ETF in the first week in March, up £130m from the previous week.

For many traditional investors, junk – or high-yield – bonds are perhaps associated with questionable issuers, and institutional or professional investors. But with many private investors now turning to high-yield bond funds it is important to remind ourselves that this market was previously reserved for speculative investors, and for good reason.

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All bonds are classified according to their credit rating and will fall into one of two categories. They are either investment grade or sub-investment grade (that is, junk) bonds. Investment grade bonds are issued by relatively low-risk governments, companies and supranational organisations, and while they do not offer huge returns, the risk of default is low. These bonds carry an investment rating of AAA to BBB in the Standard & Poor’s rating system.

Junk bonds in contrast will carry an investment rating of BB or lower. They are speculative bonds where ratings agencies perceive that there is between a noteworthy and significant risk of default. As a result of the higher default risk, investors are offered a higher return, and it is because of these higher returns that these bonds are appealing to those searching for yield in this low inflation (or even deflationary) environment.

While returns in the high-yield sector are modest – the iShares Euro Yield ETF has returned 4.18 per cent over the last year, and 9.31 per cent over the last three years – importantly protections are being eroded.

The ratings agency Fitch has highlighted that European high-yield documentation has deteriorated significantly, including particularly with respect to portability – a particular feature that leaves investors defenceless and uncompensated against releveraging in the event of a change of control. As a result, the ratings agency has received demands from investors for stronger standards on new issues.

The agency also recently warned that credit market conditions are reminiscent of 2007, when cross-border investors in eurozone debt fuelled excessive credit growth.

This is not however just a European issue; Moody’s Investor Service has revealed that investor protection in new US junk bonds fell to their weakest level in the last four years, as risky borrowers are able to dictate terms to yield-starved investors. Moody’s has judged investor protection to be at 4.51 for junk bonds in February – where 5 represents the weakest protection and 1 the strongest.

What is potentially more concerning is that the risks associated with junk bonds are not limited to those who invest directly in the sector – some have argued that another financial crisis could be triggered by this very sector. The junk bond market has grown from US$1trillion to more than US$2trillion in the past four years – to reach the first trillion it took more than 35 years. What is more, Martin Fridson, a renowned authority in the high-yield sector, has estimated that nearly US$1.6trillion of junk bonds will default between 2016 and 2020 – over 75 per cent of the total market.