Credit markets reflect economic divergence

The high yield bond sector in Europe is at an interesting juncture, having finished Q3 with its first negative return since Q2 2012, as a result of a combination of geopolitical events, defaults and fund outflows. Investors are fleeing the asset class on concern that rising US interest rates will create a material shift in demand and long-term strategic allocation outflows, and are focusing once more on fundamentals, rather than the technical picture.

European and US credit increasingly resemble two distinct markets, with the latter farther along in the cycle.

 “There is an economic soft patch in Europe suggesting a recovery is still ongoing,” says Craig Ellinger, head of US investment grade and global high yield fixed income at UBS Global Asset Management.

“On the other hand, the economy in the US is comfortably in expansion mode and returning to trend. The softening of underwriting criteria is feared by some to be a sign of a turn in the credit market, but we are not yet worried about default rates. There will naturally come a time when defaults will increase – it’s just not soon.”

What investors have got wrong thus far is anticipating interest rates will rise in 2014, he believes. Despite Janet Yellen’s dovishness of late, the shorter end of the US Treasury yield curve has started to move upwards, suggesting the market believes the Fed may raise rates early in 2015.

The pace of the rate increases will be critical. “If investors are fleeing high yield because of fears of rising interest rates and liquidity concerns, they need to have a view on the pace of the rate increases,” adds Mr Ellinger. “If slow and steady, the negative impact to high yield and other risk assets should be muted. What comforts me somewhat is that everybody is talking about rising interest rates and the liquidity risk in high yield. It is a consensus opinion,” he adds.

The debate is about how deep in the cycle we are, says Darren Hughes, senior portfolio manager and co-head of high yield at Invesco. The market expects Fed tightening in the second quarter of 2015 but yields could remain lower for longer, he believes. “The credit backdrop has remained strong with improving fundamentals and top-line growth, and from an interest cover standpoint companies are at an all-time high. Even in cases where there have been legacy buyout issues, these have been able to find access to funds and maturity walls continue to get pushed out.”

A substantial proportion of the proceeds from new issues have been used to refinance old debt, rather than for aggressive purposes such as dividend payments, stock buybacks or M&A. Refinancing has accounted for around 60 per cent of funds raised over the last 18 months, compared with 35-37 per cent in 2006-7. In 2006-7 roughly half of new issuance found its way to leveraged buyouts but that has now reduced to just 20 per cent, according to Scott Roberts, senior portfolio manager and co-head of high yield at Invesco.

While there has been a small pickup in M&A, much has been strategic as opposed to leveraged buyouts and bigger equity cheques have been issued. Around 40 per cent of new issues last year were structured senior secured debt, particularly in Europe, which is attractive in difficult environments.

Mr Roberts also scotches the idea that interest rates hikes are necessarily bad for the high yield sector. Between June 2004 and June 2006, the Fed hiked interest rate 17 times, making a total increase of 425 basis points. During that 24-month period, high yield returned 15 per cent, almost beating the S&P 500.

“If the Fed raises rates but the economy still has moderate GDP growth, the high yield sector will benefit from better corporate balance sheets,” he argues.

Leverage levels are also comfortable: today gross leverage measured by ‘turns’, the multiple represented by the level of debt above the equity, stands at four turns of gross leverage compared with 4.25 turns in 2009.  Leverage at four turns or below is in a good place.

The default environment is also relatively benign with a flat default rate of 60 basis points, despite recent defaults and distressed situations such as Phones 4u, Banco Espírito Santo and Hypo Alpen Adrian.

New supply has also been plentiful; $55bn (€44bn) was issued in September last year compared with $43bn this September, but issuance may be slowing. “There has been record supply year to date but last month went rather quiet,” says Colm D’Rosario, senior portfolio manager high yield at Pioneer Investments.

“Absence of supply can be a good thing for high yield but there is some in the pipeline, and issuance will depend on global risk sentiment.”

There has been some weakening of documentation standards and less discipline in new supply over the last year but weaker performance of this supply over recent weeks should be helpful as it is encouraging investors to examine fundamentals and should bring some discipline back to the market, he explains. Looking at European high yield and policies in central banking, rates are low in Europe and could go lower, which means European fixed income should continue to look attractive on a global basis.

“This has been a period of retrenchment driven by relative values between European high yield and the rest of the investment universe, not just versus fixed interest but also versus equity markets,” says Mr D’Rosario. “In general we think fundamentals are in good shape although there have been some isolated cases which have run into trouble.”

Pioneer believes there are some concerns about high yield from crossover money in this space and ETF outflows and that these can lead to a broad-based sell off. This would mean high quality issues such as BBs could fall in price and present opportunities, adds Mr D’Rosario.

Most managers believe they will produce a 4-5 per cent return in the coming months which will be very attractive compared with other fixed income assets.

Cocos and AT1s have been in demand in some quarters as more opportunistic plays with the same downside risk as the equity of the bank, but several teams have reduced the risk in their portfolios over the last quarter, reducing exposure to such assets and peripheral hybrids. Last year, AT1s were priced initially at 7-8 per cent but have been subsequently brought to the market at much tighter levels (5-6 per cent), which does not compare well with the return on bank equity, which is still 10 per cent, with some potential for upside.

 “The traditional approach to this market effectively forces you to lend more to the companies that have the larger borrowings, so hence Lombard Odier has a fundamentally weighted driven approach,” says Kevin Corrigan, head of credit at Lombard Odier Investment Managers.

“It has a bias to factors other than debt such as turnover, free cash flow, leverage, interest cover, and earnings growth versus debt growth. This is in contrast to traditional market-cap benchmarks for the fixed income universe which expose investors to potentially undesired credit and valuation risk by lending the most to the most indebted.”

In 2014 the best place to be was in higher rated paper with longer duration rather than less, a reversal on the previous year when the opposite was the inspired call. These can be difficult decisions for an active manager to make.

 “This is the part of the cycle that is about protecting wealth and not trying to chase wealth creation,” says Sandro Näf, portfolio manager and CEO of Capital Four Management A/S, the sub-manager of the Nordea 1 – European High Yield Bond fund.

Mr Näf believes the high yield fund universe is overpopulated. “A lot of new funds that have been set up may not survive – for example, there are more than 10 high yield managers alone in Copenhagen – and not all are needed. It is a cyclical industry that grows and shrinks as high yield spreads widen and tighten. I would not be surprised if one third or one half of high yield bond funds were not here after five years,” he predicts.

 People try to make high yield a sensational asset class, because there have been extreme returns from time to time, such as -32 per cent in 2008 and +80 per cent in 2009 (in Europe), explains Mr Näf.

“Over the long term, however, high yield has actually been more boring than people would like it to be,” he says. In 2008 the declines were driven by liquidity, not defaults, and that is why the market recovered so quickly.

“There was just a revaluation, not any permanent destruction of value, so if you had bought our fund in the summer of 2007 and held on, you would have been back in the money by Fall 2009,” says Mr Näf. “People think it is junk but actually it is a much more developed and mature asset class than often perceived by the masses.” 

The hunt for higher yields

“In the last few years we have been advising  clients to take more risk including in high yield, as a hedge against inflation,” says Florent Brones, chief investment officer, BNP Paribas Wealth Management. 

However, the wealth manager has more recently moved back to a standard weighting in US high yield, and retained the overweight position in Europe, which is lagging the cycle.

“We still hold some US high yield essentially for the carry – default rates are still low in the US,” says Mr Brones.

Clients are advised to hold until maturity to avoid risk, and the firm does not advise clients to play the game of shrinking spreads in its core scenario, although it is possible that corporates in Italy and Spain could benefit from the ECB’s moves to manage the situation.  

 Discussions tend to focus on covered bonds, rather than the financial sector per se, and each individual case is assessed on its merits, with the house view on a company’s equity and bond issuance typically running hand in hand.

 At Brewin Dolphin the mood is more cautious. “Whilst almost every investor with discretion will by now have moved underweight bonds, within that universe a lot will have felt squeezed into the high yield sector in search of yield,” says Guy Foster, head of research at Brewin’s wealth management business.

There is therefore a potentially large volume of funds invested in a relatively illiquid asset class, which would under normal circumstances prefer to be in either equity or investment grade, he warns. 

Anything which might prompt a flight to investors’ preferred habitat – for example a rise in interest rates or default rates, has the potential to be painful for high yield.

“The question is whether you feel adequately compensated by yields currently on offer,” he adds.

At any rate, high yield bond managers should be implementing liquidity-oriented strategies to mute the impact of outflows.

For investors large enough to buy bonds direct, Carter Brod, a partner of global law firm Morgan Lewis, points out that the investor must thoroughly understand the covenant package and where the balance lies between the protection of its interests and the flexibility of the issuer.

“While there is a standard framework for a high yield covenant package, the covenants are tailored to meet the characteristics of a particular issuer and deal on a case-by-case basis, and can have an impact on the value of the investment, the risks and returns,” he says.

 High yield covenants are designed to preserve the issuer’s assets so that the issuer is able to satisfy its obligations, including making payments on the bonds, says Mr Brod. The covenants also limit the issuer’s ability to make payments of cash to creditors or investors other than bondholders, so that there is sufficient cash to pay the bondholders. 

“At the same time, high yield covenants are intentionally flexible enough to enable the issuer to run its business and adapt to changes during the life of the bond,” he adds.

VIEW FROM MORNINGSTAR: Bankruptcies blur an otherwise bright picture

Year-to-date to 30 September, the Morningstar USD High Yield Bond category returned an impressive 10.8 per cent (in euro terms) while the EUR High Yield Bond peer group delivered more muted returns (3.54 per cent).

Sub-investment grade issuers benefited from a generally low interest-rate environment. However, in the third quarter, global high yield credit spreads widened by approximately 50 basis points, bringing them to an average of 400 basis points above the risk-free rate, offsetting much of the tightening from earlier this year.

While default rates remain limited (at around 2 per cent on average in Europe and the US), the quarter saw some notable and unexpected bankruptcies in the high yield space. For instance, in September, the UK mobile phone retailer Phones 4U collapsed following Vodafone’s announcement that it would not be renewing its contract with the company.

One of the largest funds in the EUR High Yield Bond universe, Pioneer Funds Euro High Yield, rated Neutral by Morningstar, returned 3.13 per cent year-to-date, slightly below the category average of 3.54 per cent. The fund is managed by Colm D’Rosario who joined Pioneer in 2007, but only became the strategy’s lead portfolio manager in August 2013, following the departure of the previous manager.

The fund focuses on lower credit names (particularly issuers rated B or below), where the team believes there are more opportunities to add value through issuer selection. This strategy has unsurprisingly produced high risk metrics (over five years to the end of September 2014, the fund’s standard deviation is 30 per cent higher than the average peer’s), but has so far failed to deliver significant outperformance. Over three years, the fund ranks in the 49th percentile of its category.

On the other hand, HSBC GIF Euro High Yield Bond, rated Silver by Morningstar, was one of the category leaders over the year-to-date period, returning 4.93 per cent.

Manager Philippe Igigabel prefers issuers that he believes are relatively insensitive to the economic environment, either because of their business model or the soundness of their fundamentals. For example, he has long been convinced that banks have considerably cleaned up their balance sheets after the credit crisis of 2008, and thus he has maintained a significant overweight in subordinate financial debt for the past five years. At the same time, since 2013, he increased exposure to junior debt of non-financial issuers (for example hybrid bonds issued by EDF, Volkswagen, Orange).

Recent successful picks include Wendel, which performed strongly as it was upgraded to “investment grade” status in July.

Finally, High Yield Bond ETFs, once a rarity, have started to gain some traction in the fixed income space. For example, the SPDR Barclays Cap EUR High Yield Bond returned 4.62 per cent year-to-date, significantly above the category’s 3.54 per cent. Such funds’ low fees are clearly a structural advantage compared to active competitors: they typically charge annual fees of around 0.5 per cent while the retail category median for active funds stands at 1.4 per cent.

Mara Dobrescu, fund analyst, Morningstar