Returns during a downturn

Financial markets have been hit by unprecedented volatility over the past three to four months. This is one consequence of the well publicised credit crunch and de-leveraging around the world. The spark, but not the only cause, for the credit crunch and de-leveraging was a rise in defaults in the US subprime market. This and other factors have led to volatility in equity markets and widening bond spreads. High yield bonds have suffered more than investment grade bonds as risk aversion has risen. Paul Reed, manager of the Aberdeen GI-Euro High Yield Bond fund, for example, says that during July, the spread on the JP Morgan European High Yield Bond index widened by 121 basis points to 344 basis points. By September, spreads had widened to 420 basis points, says Henrik Ostergaard, manager of the Nordea 1 European High Yield Bond BP-Eur fund. This means they have widened 190 basis points since the start of 2007. While the European high yield bond market rose 8.7 per cent in 2006, it fell 3.4 per cent in July 2007 and 2 per cent in the first eight months of 2007. Warning signs Some fund managers say they were prepared for the volatility in the markets. They include Anthony Robertson, manager of the BlueBay High Yield Bond fund. “There were warning signs about US subprime that were relayed to the market in February. But much of the market decided to ignore these signs. We took a more defensive position by raising cash, investing in high quality paper and reducing duration.” Ian Spreadbury, manager of the Fidelity Funds European High Yield fund, says that before the market correction it had become harder to find value, and that spreads on B rated bonds reached 200 basis points earlier this year, which was an historical low. As a result of less value being available, Mr Spreadbury began to search further afield for investment opportunities. He is able to invest up to 30 per cent of the fund outside his core universe of European high yield bonds, including investment grade bonds. For example, Mr Spreadbury says Asian high yield bonds offer more value than European high yield bonds. This includes palm oil and coal producers in Indonesia and Australia. Mr Spreadbury has also found investment opportunities in other emerging markets, including emerging Europe and Russia. The fund hedges currencies back into euros. Mr Spreadbury says he is a large investor in bonds financing the oil rig sector. He argues that the fundamentals are strong in this sector and can offer yields of 10 per cent. The other area where Mr Spreadbury has invested are floating rate notes. Around 5 per cent of the fund is retained in cash and government bonds to ensure the fund has liquidity to meet redemptions. Has the widening spreads increased investment opportunities in European high yield markets? Or will the fall in US house prices and the credit crunch lead to lower consumer spending and business investment as liquidity has been tightened? Mr Reed believes there are now more investment opportunities, arguing that widening spreads have been largely based on contagion fears, in particular the impact of potential redemptions from hedge funds, rather than investment fundamentals. Traditionally, high yield spreads are strongly correlated with economic growth and company prospects. “Unlike the start of the global slowdown six years ago, investment fundamentals in the European high yield market are now robust,” says Mr Reed. “Economic growth in Europe and the rest of the world is set to be reasonable this year and next. Individual credit exposure to the US subprime market is low and company results continue to be strong. We derive comfort from earnings releases and company forecasts for the remainder of 2007 and, without being overly bullish, we remain upbeat.” Mr Reed also points to default rates as supporting his view. “The European issuer-weighted speculative grade rate finished the second quarter at 2.2 per cent, down from 2.8 per cent at the end of the first quarter. Moody’s forecasting model indicates that the speculative grade default rate is likely to rise marginally in the short run but remain well below the long-term average for high yield of around 4.5 per cent.” Mr Robertson at BlueBay says there is more value available in the high yield market through the widening of spreads over the past couple of months. This value, however, is available selectively in individual bonds rather than in any particular sector. The one area highlighted by Mr Robertson as beginning to offer better value are senior fixed rate notes. Nevertheless, Mr Robertson says his fund is still positioned quite defensively. “We have been investing some of the cash selectively where we find opportunities.” This defensive stance is because of the remaining uncertainty surrounding future economic growth, says Mr Robertson. “There will be an economic slow down. It is a question of the degree of the slow down. The more severe the slow down the greater spreads will widen. “If consumer spending slows significantly, corporate earnings and profits will be hit and default rates will rise. Recession is not the most likely scenario from here but there will be a slow down. Rate reductions by the Federal Reserve alone will not be enough. Greater clarity will appear once the third quarter earnings season gets into full swing in October.”

	‘The five-year performance is not as strong because the fund grew very quickly in 2003 and 2004’ - Ian Spreadbury, Fidelity
	‘We derive comfort from earnings releases and company forecasts for the remainder of 2007, and we remain upbeat’ - Paul Reed, Aberdeen
	‘While high yield spreads have increased, they are also more volatile’ - Henrik Ostergaard, Nordea
	‘There will be an economic slow down. It is a question of the degree of the slow down. The more severe the slow down the greater spreads will widen’ - Anthony Robertson, BlueBay

Mr Ostergaard says investment opportunities are being offered by the lack of differentiation in the market. “Many borrowers have been coming to the market with deals with very high leverage and small equity cushions. Surprisingly, the most risky bond issues have not suffered more than the overall market in the recent downturn. “On the other hand, we have seen too large corrections in the safer senior secured bonds. Consequently, we continue to like the senior secured part of the high yield market and we continue to avoid subordinated bonds with little equity cushion. The European high yield market fundamentally looks attractive at current levels and a return of 7 to 7.5 per cent is likely over the next 12 months.” Spreads stabilising Mr Ostergaard points to German manufacturer Grohe as an example. He says it has floating rate notes on spreads of 400 basis points, which is a yield of around 8.6 per cent. “This is attractive when riskier high yield debt is on 10 per cent yields.” Mr Ostergaard believes spreads will stabilise over the next 12 months “as the main market driver, the default rate in Europe, is still low at around 2 per cent to 3 per cent. “While high yield spreads have increased, they are also more volatile and so high yield strategies should be oriented defensively.” He highlights the distressed rate as a future indicator. Over the past couple of months, the distressed rate in the US has risen to 4 per cent. In Europe it is 1 per cent. The distressed rate is the percentage of issuance that has spreads of more than 1000 basis points wider than government bonds. Mr Ostergaard believes senior debt spreads will narrow although he stresses it is unlikely to occur over the next month or two. Mr Ostergaard adds: “The corporate fundamentals are strong with good earnings and balance sheets. With spreads in their current position, the default rate could rise to 6.7 per cent. This is effectively what the market is pricing in. That would mean 30 per cent of companies disappearing over the next five years.” Mr Spreadbury is still cautious following the volatility in financial markets. But he says there are selective investment opportunities and does not expect a recession in the US because the Federal Reserve has reduced rates as it strives to improve growth. Furthermore, he points to continued strong economic growth in Asia. A bottom-up, fundamental investment approach is commonplace among the best performing funds in the European high yield sector. Mr Ostergaard, for example, says the Nordea 1 European High Yield Bond fund tries to take “bottom-up focused bets, looking on a name-by-name basis. Then afterwards, as we are so bottom-up focused, we employ a risk management and performance attribution process. “This enables us to identify the contribution from every bond in the benchmark and where we probably need to change the risk if anything has changed in the portfolio.” In analysing bonds, Mr Ostergaard says Nordea develops its own profit and loss and balance sheet of each company and “how we think that is going to develop going forward”. The Nordea fund, which has been ranked third, fifth and second in the sector over the past one, three and five years respectively according to Morningstar, can invest up to 6 per cent in a single bond and a sector weighting of plus or minus 30 per cent against the benchmark. Mr Robertson of BlueBay says he also takes a fundamental bottom-up approach in selecting high yield bonds. Among the factors he looks for in companies are strong cash flows, transparent earnings and strong industry positions with high barriers to entry. He says there is an emphasis on capital preservation in managing the fund. Mr Robertson also conducts two types of relative analysis. The first is comparing the value of high yield bonds against the price of other high yield bonds in the same sector. Second and more importantly, is comparing intra capital structures. This involves evaluating the value of all the debt instruments of the same company, including investment grade and payment in kind debt, to see which offers the best risk reward profile. The BlueBay High Yield Bond fund returned 95.12 per cent over five years to 10 September 2007 against 86.87 per cent by the Merrill Lynch European High Yield Master index, according to Morningstar. The value of liquidity Mr Spreadbury at Fidelity says he takes a bottom-up fundamental investment approach as well. Among the factors Mr Spreadbury looks for when investing in bonds are companies with strong cash flows and liquidity. He says that while high yield companies are highly leveraged, he invests in companies that are de-leveraging. Mr Spreadbury is cautious about companies that are looking for top line growth to de-leverage, however. “We analyse absolute and relative valuations, the latter being against companies’ sectors and on an historical basis over the past 23 years. The 23 years of historical data include default rates, upgrades and downgrades.” Over five years to 10 September 2007, the Fidelity Funds European High Yield fund returned 57.39 per cent against 86.87 per cent by the Merrill Lynch High Yield Master index. But over one year, the fund returned 2.09 per cent compared to 1.81 per cent by the index. Mr Spreadbury says the five-year performance is not as strong as the one-year performance because the fund grew very quickly in 2003 and 2004. “During 2003 and 2004, it was challenging to invest the amount of inflows we were receiving and the amount of dealing required affected costs,” says Mr Spreadbury. Fidelity adds that since launch on 27 June 2000, the fund has delivered more than twice that of its benchmark with a return of 35.9 per cent.