Focus turns towards high yield debt

Bond returns have been fantastic for the last two years, with high yield delivering over 60 per cent in 2009, and a still-attractive 15 per cent last year. Any remaining scope for spread contraction is therefore limited, and the market has consequently become yield-based, with fund managers managing down their clients’ expectations towards mid-single digit returns.

However, this is a well anchored market, supported by improving corporate balance sheets, strengthening credit quality and enduring investor demand for income.

DECENT RETURNS

“The return on the asset class in 2009 was a once in a career opportunity – spreads were at an all-time wide and we enjoyed the fruits of their contraction,” says Paul Read, co-head of fixed income at Invesco.

“That lasted through that year and into 2010. We are left with a market where there is no obvious opportunity for additional spread contraction but which for the most part will provide you with a decent yield-based return.”

The future for corporate bonds now depends on what the European Central Bank (ECB) does about rates – whether there is a meaningful rate hike or a modest adjustment, says Mr Read. “If you believe, as we do, that inflation will ultimately moderate and yields remain modest for some time, then this is still an asset class that can deliver a decent return over the risk-free alternatives. Over the next 12 months, we’re really looking at this as a yield story – there are only one or two parts of the market where we might also anticipate further spread tightening.”

The focus has turned away from investment grade bonds, which are more sensitive to rate rises, towards high yield, where that small further contraction may occur.

“Although corporate bond valuations are nowhere like as attractive as they were at the start of 2009, with BBB+ spreads currently at an average of 170 basis points over government bonds, they are still at the point they were in 2002, even though corporate balance sheets are in much better shape today,” says Raphael Robelin, senior portfolio manager at BlueBay AM.

“If you look at historical default statistics, using Moody’s default and migration statistics going back to 1980, investors have typically only needed 19 basis points to compensate for the credit risk when investing in BBB+ corporate bonds for five years,” he explains.

“Even during the worst five-year period on record, in 1998-2003, when there were several fraud cases including Enron and Parmalat, investors only needed 47 basis points of compensation for the default risk they faced, so it is hard to argue that you’re not being paid attractively for risk at current levels.”

 LOW DEFAULT RATES

Default rates should stay low, according to indicators such as the latest forecasts from ratings agency Moody’s, and the Schroder Global Credit Trend Index, which is based on an assessment of over 1,000 corporate bond issuers.

“While economic growth is likely to be modest, it should be enough to give a positive backdrop for attractively valued corporate bonds, which we believe largely reside within the more cyclical and economically sensitive parts of the market,” says Adam Cordery, fund manager at Schroders.

However, there is a certain downside associated with businesses accumulating cash on their balance sheets – they may be tempted to use it to keep shareholders sweet or to embark on further leverage such as debt-financed M&A and Capex increases.

“We’re likely to see more shareholder-friendly behaviour,” says Jamie Guenther, head of US Institutional Credit at DB Advisors. “Probably the biggest dynamic is an increase in M&A and share repurchases and theoretically these are credit ‘unfriendly’ and place restraints on spread performance going forth.”

Historically, credit has performed well when growth in developed economies is between 1-3 per cent, which sits well with current levels. “Any less and defaults rise, but if growth is stronger, then managements often become too bullish,” says BlueBay’s Mr Robelin.

Like many managers, he currently prefers the lower end of credit spectrum – crossover and BBBs – because this group of companies is generally focussed on financial discipline and committed to their credit ratings. It is managers of higher rated investment grade companies that are under most pressure to take on additional debt to boost their stock price and keep shareholders happy.

A lot hinges on whether government bond yields move much higher. While inflation is creeping up, the sources are cost push – a combination of energy and commodity prices, and there are impediments to growth which are a drag on inflation such as limited lending. This is therefore not a backdrop in which the labour market has much power to respond to higher costs, and inflation and rates are likely to stay modest.

Flows into EPFR global-tracked bond funds have been strong all year, with the recent spike in risk aversion reflected in additional inflows taken by global funds which hit a 55-week high in May, as investors seek out managers who can extract value in a range of markets, crucial when growth is anaemic. Strategic bond funds that can access the spectrum of fixed interest and deploy derivatives are enjoying particular demand.

Some bond funds have recently altered their mandate to increase the proportion allowed in high yield bonds, which indicates that fund managers are not finding attractive opportunities elsewhere. Managers who run strategic bond funds that can access the spectrum of fixed interest and deploy derivatives are enjoying growing demand.

“Until last year, investment grade bonds were grasping most of the inflows, but since the beginning of the year we’ve seen a shift in demand towards high yield and more flexible management in credit,” says Benjamin Conquet, investment specialist at BNP Paribas Investment Partners.

“Most traditional IG funds follow one of the indices such as Merril Lynch and Barcap, but for those who are uncertain how rates will go, there is a significant interest rate duration in investment grade to consider, so we’ve seen a reduction in inflows into investment grade while high yield has been collecting inflows as the sector is less sensitive to rates. The switch we’ve seen from private banks is to a flexible allocation to credit, where the manager has greater freedom to pursue opportunities.”

For example, the Parvest Flexible Bond Europe fund has a modified duration capped at two years, so any noise in the rate part of the curve will make little impact, compared with 4-4.5 for a traditional investment grade fund. The fund is also concentrated, with just 70-80 holdings – many fewer and manager Luca Pagni says “that would mean taking on too much credit risk and that is not well paid in these converging markets”.

Advisers are also concerned that general funds benchmarked to a relevant standard index are forced to carry a very high proportion of financials, generally 40-60 per cent.

“We are concerned about the quantity of financials in many bond funds, and how far down the debt structure various governments would honour debt contracts in the event of nationalisation,” says StJohn Gardner, CIO at private bank Arbuthnot Latham.

“While this strategy could be profitable if the fund manager got it right, we would not wish to put our clients at risk. Our approach to finding fixed interest exposure for clients is to be extremely underweight the whole corporate bond area.”

FINDING VALUE

However, some managers believe the financial sector is in a multi-year process of repair and remains one of few places where there is still value, benefiting from a combination of regulatory reform, balance sheet refinancing, and cyclical recovery.

“In euro markets, aggregate tier one in banking is on an average spread of 5 per cent, but for most other sectors, it is just 100-150 basis points, roughly the long-term average,” says Invesco's Mr Read. “In a weak market, tier one bonds are often the weakest. There are still the peripheral problems that could unsettle investor sentiment towards banks but many banks are holding more capital than for a long while.”

Although managers have moved farther down the risk spectrum looking for yield, they are reducing exposure to European credits where the underlying issuer has exposure to peripheral markets, according to Richard Ford, fund manager at Morgan Stanley. Many have added to their positions in safe havens such as the US and Germany as the Greek problem intensified.

“The restructure had been based on assumption that Greece, Ireland and Portugal could re-enter the capital markets after their temporary liquidity problems had been overcome, but in fact the gap between growth and debt payments has ballooned,” says Tanguy Saout, head of fixed income, investment grade at Pioneer Investments.

“Greek growth has fallen by 4.8 per cent, while the yield on its 10-year bonds is 16.8 per cent. The latest Ecofin (Economic and Financial Affairs Council) meeting refrained from finding a second rescue package for Greece. There is no consensus about what to do, however, such as whether to extend maturities, lower coupons, or a lower redemption value,” he explains.

“The ECB is most vocal in its opposition, and this may prove an additional risk factor as it keeps alive the crisis scenario and may even fuel fear that other countries may have their debt restructured.”

 Wealth managers cooling on corporates

Wealth managers are no longer enthusiastic about the corporate bond sector, and where they do recommend funds there is a preference for strategic funds that can take advantage of the broader opportunity set and also use derivatives to ship out duration risk.

Butterfield Private Bank usually buys bonds direct, and uses external funds mainly for high yield and emerging markets. “We spend a lot of time assessing whether the funds and managers are themselves ‘investment grade’, irrespective of the asset class they invest in, says David Stewart, CIO of Butterfield Group.

“The structure of the asset class also has implications for the use of active managers. In a relatively ‘imperfect’ market such as emerging market debt, there is evidence of a consistent ability to outperform, but in more efficient markets, this is difficult to find,” he explains.

“At the moment, the risk return profile of investment grade bonds is not as attractive as the return for other asset classes, so we have taken a long hard look at how else we can gain fixed interest exposure,” says StJohn Gardner, CIO at Arbuthnot Latham.

He explains how, for example, the UK-based private bank is looking at strategic bond funds which have the flexibility to invest anywhere from pure gilts all the way up to high yield and other forms of fixed interest.

“What we’re finding is a lot are heavily bunched in the high yield space because they feel there is little additional value in investment grade,” says Mr Gardner. “But we believe in six months high yield will also be fully valued – returns at the moment are 6-7 per cent in income and 3 per cent capital growth, and most of the latter will take place in the next six months so from the beginning of 2012 it will be purely income.”

Mr Gardner also looks at the skills of the managers in “quirky parts of the bond markets”, such as euroloans or floating rate notes (FRNs), which are less sensitive to rate changes, because the coupon is linked to Libor – generally Libor plus 3-6 per cent. He suggests the L&G dynamic bond trust, Cazenove’s Strategic Bond Fund, which is currently focused on FRNs, and M&G’s specialist European Loan Fund.

Diversifying by style can also prove advantageous. “Managers have different styles in managing currency, duration, yield curve and credit selection,” says Jane Davies, senior portfolio manager at HSBC Global Asset Management.

HSBC uses a blend of managers in its sterling, global aggregate and high yield manager of managers funds, including Fidelity, GS and Royal London.

Ms Davies also prefers an active manager in the lower credit ratings, pointing out that tracking high yield leaves one owning the CCC bonds that may be close to default in the index.