Optimism presides but one eye on US

The economic environment has favoured high yield bonds over the past three years. Global growth has been strong while corporate earnings, cash flow and balance sheets have generally been improving. This is reflected in the fact that the Merrill Lynch Euro High Yield index has returned 32.40 per cent in the three years to 11 September 2006. Spreads over government treasuries are at historically tight margins despite the correction in May and June. Default levels in Europe are also at very low levels. The question facing investors is whether the credit cycle is about to change and investors risk suffering capital losses over the next year. This is partly prompted by concerns over a slow down in global economic growth later this year and into 2007. Ian Spreadbury, manager of the Fidelity Funds European High Yield fund, is a believer that the credit cycle is turning. “There are still plenty of investment opportunities but some valuations are looking stretched. With a turn in the credit cycle, the rate of defaults is likely to rise. This is partly because of the amount of issuance of B bonds.” He has taken a more defensive approach in his portfolio in anticipation of the change in the credit cycle. The average credit exposure is around a high single B compared to the long run average of B to CCC. “The strong corporate balance sheets have happened and now we are coming out the other side,” says Mr Spreadbury. “It is likely the global economy will slow down later this year. We are seeing a slow down in the US housing market although this is being partly offset by lower oil prices.” Mr Spreadbury has also been increasing allocations to new areas, notably outside the European Union where he will typically invest up to 10 per cent. “We have been increasing our exposure to Eastern Europe and Russia as well as South Africa and Asia.” He adds that he takes a long-term view on his holdings and therefore may under-perform in the short term. Over the past year, for example, the fund has returned 5.54 per cent against 6.14 per cent by the Merrill Lynch Euro High Yield index. But over five years, Fidelity Funds European High Yield has returned 54.83 per cent compared to 36.66 per cent by the index. Mr Spreadbury says many different disciplines are required when managing a high yield fund. This includes having credit, trading and legal teams. “The trading team is important because high yield bonds can be a fairly illiquid market. “We have the largest fund in the sector and therefore our investments can take longer to complete. I may need to invest £20m in a single bond. “We have the legal team because high yield bonds have different terms and conditions. It is vital we understand these before we invest.

‘We believe we are in a fairly benign economic environment. We are, however, keeping an eye on the US economy, particularly the housing market’ - Gary Clarke, Schroders

“The quant team then analyses the relative and absolute valuations of bonds. This includes looking at supply and demand. Strong selling reduces liquidity and prices.” In deciding whether to invest in bonds, Mr Spreadbury says he places a strong emphasis on cash flows and liquidity. “This is because high yield companies use a large degree of leverage. “We also look at the risk of default and downgrades. We have data going back 25 years that shows how many bonds of each rating on average suffer default and downgrades. This helps us to make a judgement on whether we are being paid enough for the risk we are taking.” The lack of liquidity can impact on performance because of higher transaction costs. In 2003 and 2004, for example, there was a 2 per cent bid offer spread on high yield bonds. Per Wehrmann, manager of the DWS Euro-Corp High Yield fund, says he takes a bottom up approach to selecting bonds. “We have a diversified fund in which each holding does not comprise more than 3 per cent of the portfolio.” When reviewing high yield bonds, Mr Wehrmann says he analyses the worst-case scenario for companies, their cash flow and the likelihood of the company de-leveraging.

Wehrmann: economy will move sideways

He splits high yield bonds into three different baskets. These range from stable companies generating a steady return up to high risk, high volatile and potentially high return holdings. The degree to which Mr Wehrmann allocates between these three baskets depends on his outlook for the economy. The more optimistic he is then the higher allocation he makes to the more volatile companies. “We believe European economies will move sideways. This means spreads may widen but we would not expect them to do so by more than 50 basis points. “This is because the fundamental factors are looking positive. This includes good liquidity in the high yield market while companies face a benign economic environment. Spreads did widen in May and June but they are almost fully back to previous levels.” This is reflected in the historically low percentage of defaults among European high yield bonds, which are put at anywhere between 0 and 1.5 per cent. Mr Wehrmann says: “We expect the default rate to rise to 2.5 per cent to 2.7 per cent next year. But this is still low on a historical basis. We do not see this increasing significantly as companies are well funded.” Despite the optimistic view, Mr Wehrmann says investors should not expect double digit growth from high yield bonds over the next six months and year. He expects the return to be around the average coupon rate of 6.5 per cent. The biggest risk is a significant slow down in European and global economies, says Mr Wehrmann. “A US recession would lead to higher default rates and spreads widening. Spreads could widen by 200 basis points in this situation. But this is not my main scenario. I believe the most likely scenario is a soft economic landing. “There are also some threats in Europe, including an increase of 3 per cent on VAT in Germany from the start of 2007. This could impact on corporate investment and thus economic growth.” Paul Reed, manager of the Aberdeen GI-Euro High Yield Bond fund, says he manages a diversified portfolio of around 100 bonds so there is little risk of individual names seriously impacting on the overall performance of the portfolio. He argues that investment grade bonds offer few investment opportunities at the moment. “High yield bonds have greater correlation to small cap equities than government and investment grade bonds. When the rate of inflation is rising steadily then this favours equities and high yield bonds.”

Pesquès: SGAM overweight in high yield

Mr Reed says the average spread for European high yield bonds is 300 basis points. While the average yield is around 5.5 to 6 per cent, Mr Reed says new issues have yields closer to 8 or 9 per cent. “This is a reasonable yield in the current environment.” He believes new issues present investment opportunities as well as those companies that are de-leveraging. The impact of rising interest rates depends on how successful the European Central Bank is in reducing inflationary pressures without derailing economic growth, says Mr Reed. If rising rates drag down growth too much then this will negatively impact high yield bonds. It is not only European interest rate movements that are important but also those in the US as it could impact on economic growth on both sides of the Atlantic. John Lupton, manager of the Fortis L Bond Corporate High Yield fund, says he focuses on cash flow when analysing companies because they are highly leveraged. “Cash flow is important because their debt obligations are a high proportion of their cash flow. “We evaluate current cash flow and whether cash flow will improve in the future through cost-cutting, increased income or releasing a new product. “There are different types of future cash flows – those over which the company has control and those over which it does not. For example, a company has control over whether it is to sell a property. But if a company releases a new product, it will not be sure how that will sell. “Some sectors generally have more predictable cash flows like cable TV while others like industrials have unpredictable cash flows. “As well as the degree and predictability of cash flows, we also analyse it in relation to the leverage of companies. The key is to understand companies and their obligations.” When analysing spreads, says Mr Lupton, it is important to look at the international context and the current economic environment. “We look at the US because the market has been around longer than in Europe. The average spreads over government bonds have been 550 basis points. “When the economy slows down and the market is not good then spreads tend to be in a range of 600 and 1,000 basis points. As the economy improves and demand for high yield bonds rises then spreads move to a range of 300 to 500 basis points. In Europe, spreads are around 290 basis points at the moment so they are at the bottom end of the range.” Mr Lupton expects spreads to widen as the global economy slows down next year but to stay within the 300 to 500 basis points range. “We believe we are in a fairly benign economic environment. We are, however, keeping an eye on the US economy, particularly the housing market. Sharp falls in house prices affect the amount of wealth consumers feel they have.” But he adds that when looking at historical spreads, it is important to realise there are structural differences between the high yield markets in Europe and the US. “The high yield market is younger in Europe and many companies have been downgraded from investment grade. Some are on their way back to investment grade and therefore are on relatively narrow spreads. “The average maturities of bonds are lower in Europe as well. They are an average of four years in Europe compared to eight and a half to nine years in the US. The lower maturity leads to tighter spreads.” Jon Uhrig, manager of the Mellon Global High Yield Bond fund, says there are other differences between the US and European high yield markets. He says default rates at the start of the year were 2 per cent in the US. “Rating agencies expected default rates to increase to 3 per cent this year but in fact they have fallen to 1.2 per cent. “In Europe, default rates on a 12-month rolling basis are effectively at 0 per cent. US high yield spreads have widened by around 30 to 40 basis points this year while there has been little movement in European high yield spreads.” One reason for the tightness of spreads in Europe, says Mr Uhrig, is the lack of new issuance. One upcoming new issuance is Phillips. Mr Uhrig says he has seen the best investment opportunities in European high yield this year in some of the few new issuances. Mr Uhrig admits that one threat to the high yield market is an economic slow down in the US and globally. But he believes the world will remain within the current economic environment. “The second quarter earnings figures were good. If this continues and demand for high yield bonds remains strong then the outlook for the sector will be good. We do not expect capital gains but we do not think there will be losses either.” Gregoire Pesquès, manager of the SGAM Fund Bonds Europe High Yield fund, says the fund aims to minimise default and downgrade risk over the medium term. “Our analysis involves evaluating under which circumstances a company may experience liquidity problems or it may miss payment of its coupon. We do this to try to reduce the risk of defaults in the portfolio. “The level of exposure within the portfolio to default risk will be determined by our view of the market environment. If we are optimistic then we will increase our exposure to riskier bonds. If we are cautious about the market then we will adopt a defensive exposure and invest in bonds with high transparency.” Mr Pesquès says SGAM is over-weight high yield because it is optimistic about the fundamentals in the asset class. He believes default rates will remain low. Mr Pesquès argues that comfort is provided by the fact that companies have the cash to pay down debt. “We are also optimistic because we believe we are in the middle of the mergers and acquisitions cycle and there is continuing refinancing of companies, in which some buy back bonds at a premium.” Another positive factor is the low volatility among high yield bonds, says Mr Pesquès. He says the volatility is a little above 2 per cent compared to 3 per cent for government and investment grade bonds. He says investors should expect the coupon plus a little extra from high yield bonds. This will mean returns in the region of 6.5 to 7 per cent.