A rare opening for Long-term buyers

sHigh yield bond spreads have widened significantly and are now at levels not seen since early 2003, arguably presenting a rare window of opportunity for those who can stomach some volatility. At 850bp over Government bonds, current spreads are over three times higher than at the lowest point in June 2007. The ten-year average is around 550bp, but the asset class fluctuates between bouts of euphoria and bouts of depression and over the last 10 years spreads have ranged from around 300-1000bp and default rates have ranged from less than 2 per cent to nearly 11 per cent. Currently, the market is pricing in an 8 per cent default rate, but the incidence of speculative-grade bond failure is 2.7 per cent. Moody’s is predicting default in the high yield sector will rise to 4.9 per cent by the end of year, and to 7.4 per cent in 12 months’ time. The consensus among fund managers seems to be that this is an overstatement, and a moderate increase to perhaps 5-6 per cent in 12 months is more realistic. Triggering defaults One argument Moody’s raises is that covenants have been weaker and triggers for defaults are less onerous than in the past so companies could be in worse shape than they appear, defaults could be taking longer to materialise and lower recovery rates will result when the rot starts to show. Seasoning will also impact debt taken on in 2006 and early 2007 at some point next year. “If you lend someone money they can probably survive for a year or two but the wheat is separated from the chaff in the second year,” points out Ryan Blute, vice president of European credit at Pimco. “In years two and three we start to see if the business model is effective, whether they are delivering and can pay down their debt,” he adds. One focus is to identify overcompensation. The speculative-grade market is prone to overcompensate for default risk at times, although there are short-term periods when this is not the case. “We’re still of the view that we will see more defaults coming into the market with a drift wider in bond spreads,” says Paul Brain, manager of Newton’s European High Yield Bond Fund. “What we’re looking for is an overshoot scenario. The market could get scared and factor in 10-11 per cent, so presenting a significant opportunity.” Brain expects to increase his weighting in high yielders from the current 9 per cent to 50 per cent in six months. Trudie Rothery, credit investment specialist at Threadneedle, says a recurring question from investors focuses on the early 2000s when spreads went out to 1,000 basis points and they now often ponder whether they should wait until spreads again reach those kinds of levels. However, Ms Rothery says that there were some very specific influences that contributed to spreads being so big at that time, firstly the terrorist attack on the Twin Towers and then the accounting scandals, exemplified by Enron and Worldcom. The market was also different in 2000, particularly Europe where telecoms were a disproportionate part of the market and suffered defaults. While there may always be shocks around the corner, Ms Rothery concedes that now may be the time to start looking for potential opportunities. Economically sensitive cyclical stocks that a few weeks ago were not even on the radar may begin to offer pockets of value. Dispersion in spreads Opportunities are also presented by the dispersion in spreads between the top and bottom ends of the market, a gap which has been blown wide open. In June 2007, there were only 321bp separating the highest and lowest yields between the 10th and 90th percentile credit in the European high yield market. This has ballooned to 1172bp, a fruitful environment for bottom-up name selection The risk is always of coming back into the market too late. “The market already factors in a significant risk premium,” says Grégoire Pesquès, head of credit management at Société Générale Asset Management in Paris, who expects companies to be a little disappointing, but also warns that the official default rate is a lagging indicator of performance. “Investors should generally invest prior to the peak in defaults,” he says. “The worst year of rotation was in 1990-91, when the default rate was 10 per cent but that year high yield bonds returned 40 per cent.” Despite poor visibility in the short-term, Mr Pesquès has therefore slowly increased his exposure to the market and built flexibility into the portfolio, for example by way of a bucket of CDS on iTraxx, and a focus on finding bonds that are liquid. “If you believe what spreads are telling investors, the fate of many European companies is relatively bleak and a major period of defaults could be just around the corner,” says Paul Reed, head of high yield at Aberdeen Asset Managers. “However, our day-to-day analysis suggests quite the opposite. The inherent credit fundamentals of the European high yield universe are, in fact, the best since market inception. Credit metrics such as interest coverage and leverage ratios are now at historic lows, implying that the market is well positioned to weather any meaningful downturn in economic activity,” he explains. “Furthermore, relatively few companies in the high yield market need to access the bond markets over the next two years, so refinancing risk is minimal, even in the face of weak credit markets,” says Mr Reed. “The US will be the big driver on the economy,” says Fatima Luis, manager of the F&C Extra Income and Strategic Bond funds. “We’re getting poor news but mixed news as well – for example, the GDP figure was pretty strong for the second quarter. Inflation is the other big factor and while headline inflation is high, core inflation is lower and will be less of a concern as oil comes off.” The Fannie Mae and Freddie Mac bail-outs could encourage buyers of mortgage backed securities back into the market and get the mortgage market moving again. The European primary issues market is still moribund – there were none in Europe between June 2007 and September 2008 – but new issues coming through in the next few weeks could mark a turning point. Trigger to momentum Chris Brils, head of high yield at Pall Mall Investment Management, says the market has seen some enquiries from syndicates since Labour Day, and that if a higher quality name in a preferred sector went ahead with an issue, it would likely be well received. Plenty of investors fled the market in the last 12 months and will be underweight the sector and may think a yield of 12 per cent, together with these wide spreads, hold out the prospect of a reasonable return. However, the market is crying out for a trigger to momentum. “The good news is really the valuation,” says Ian Spreadbury, manager of Fidelity’s European High Yield bond fund. “The question is whether there is a catalyst for fantastic capital performance and the answer is: ‘No, there isn’t’. We need more evidence of recovery in the banking sector. Until the banking system manages to get itself into better shape this volatility will continue,” he adds. Recent Bloomberg figures show that banks’ capital raising has not kept pace with write downs and credit losses – for the last five quarters (third quarter 2007 to third quarter 2008 inclusive) banks have written off $508.2bn (E350bn)and raised $360.4bn, a $147.8bn shortfall. Of that, European banks have written off $226bn and raised $184bn and banks in the Americas have written off $259.3bn and raised $154.5bn. Higher volatility Mr Spreadbury also highlights the upward pressure on risk weighted assets from higher volatility as Basle II forces banks to hold more capital when credit quality worsens. The risk-sensitivity of the new requirements amplifies business cycle fluctuations as banks attempt to reduce the procyclical effects by increasing their buffers, creating a much larger contraction in credit supply than Basel I when the economy falters. While concern about systemic risk is universal, it varies by degrees. “In my view, there is fairly solid support for the financial system,” argues Ms Luis. “The central banks and governments are committed to ensuring that banks are running smoothly so bondholders won’t see high default rates in financials compared with corporates, and they may be attractive to the buy and hold investor.” She points out that in August Alliance & Leicester issued an investment grade bond with an attractive yield, which then rose considerably on the completion of the Santander takeover. Moody’s speculative-grade corporate distress index, which measures the percentage of rated issuers that have debt trading at distressed levels, rose to 22.4 per cent in August compared with 4.3 per cent a year ago. Around 50 per cent of high yielders are currently trading at below 85 per cent par, compared with 40 per cent in 2001. If, however, you look at bonds trading at below 75 per cent par the current market is more expensive than 2001. Mr Pesquès says this reflects the improved diversification of the current European market, and the resilience of the cash generative telecoms sector. Companies are simply in better shape than in 2001, reinforced by refinancing in 2006-early 2007, he adds. “Results are still broadly positive, although certain sectors are beginning to feel the weight of rising input costs,” says Mr Reed. “While earnings may have peaked in this business cycle, we still expect many companies to achieve earnings growth and meaningful de-leveraging,” he adds. “Recent spread widening, then, seems illogical, when you compare the robust fundamentals, solid results and diverse nature of today’s environment to the defaults of the early telecoms-dominated markets,” he explains. “As the credit crunch and global economic growth fears continue, technical factors will continue to cause short-term weakness and volatility. However, we believe current wide spreads massively over compensate the likely level of defaults in Europe, which we forecast will remain some way below the long term average for the foreseeable future,” adds Mr Reed. “We’d argue that for buyers with a long-term perspective, current attractive yields and healthy credit metrics constitute the best opportunity in the asset class since market inception.”

Ian Spreadbury