High yield remains attractive in low return environment

Despite speculation about the potential for a bubble in the high yield bond market, industry specialists are relatively upbeat about the sector’s prospects. Average yields have gone to 8.5 per cent from 10 per cent at the beginning of the year, forestalling any further tightening in credit spreads, but the case for high yield stacks up on coupon alone, particularly when compared with investment grade at just 3.5 per cent, and in terms of risk adjusted returns, the high yield sector offers similar returns to equities for half the volatility.

“From a fundamental perspective most companies in our universe are performing well, have kept their balance sheets in good order and have refinanced any debt that has come through,” says Zeke Diwan, portfolio manager at Pioneer Investments.

“Even with low growth rates, companies in the European high yield universe are performing well as they largely remain cash generative as many continue to benefit from cost savings initiatives implemented during the downturn. Default rates will trend to the low single digits by year end (Moody’s December 2010 forecast 2.3 per cent) and remain at this level throughout 2011,” he explains.

“Last week, JPMorgan revised its European high yield default forecast to 1 per cent for the year end 2010 and set its forecast of 1 per cent for 2011,” adds Mr Diwan.

Some believe high yield is in its best position for 15 years, and argue that because the new issues coming through are largely refinancing rather than expansion-led, the market will avoid a re-run of the worst excesses of the loan sector in 2007.

Falling default rates

“Default rates are expected to fall because refinancing has become easier,” says Alexander Baskov, fund manager of the Pictet High Yield Bond. “High yield bonds have grown at the expense of leveraged loans, which were a popular asset class in 2007 when the size of the loan market tripled. But now it is shrinking because of the tighter lending conditions of the banks and the most likely venue for refinancing is instead the bond market,” he explains.

“Companies are not taking on more leverage; it’s not new debt, it’s replacing one kind of debt with another. That might create a bubble when debt is used for expansion in future and that future may not be all rosy – there will also be volatility because of the government debt problem in Europe – but corporates are in better shape than governments and in the near past that was never the case.”

Estimates for the volume of leveraged loan and high yield bond refinancing in Europe is massive, ranging from €300-500bn from now until 2017, according to Standard & Poor’s. This robust new issue calendar has produced issues that are more attractive than the last wave with substantially less leverage. Some issues have made an immediate trading profit, says Karen Bater, director of high yield at Standish Mellon Asset Management, citing an eight-year piece of paper that had risen by 3 points since issue two days previously.

Unlike some of her peers, Ms Bater likes CCC-rated bonds she believes stand a good chance of being upgraded, especially those companies that are moderately leveraged, generating free cash flow, and having some financial flexibility – primarily not much debt with a near-term maturity, good asset protection and not many bank loans higher in the payout hierarchy. B-rated bonds are currently on spreads of around 600 basis points, compared with over 900 for a CCC-rated bond.

Attractive pricings

“Right now there are a lot of opportunities in the fallen angel space and new issues are particularly attractively priced and have good credit fundamentals,” agrees Sandro Naef, portfolio manager of the Nordea 1 – European High Yield Bond Fund from Capital Four Management.

“Spreads have come in and there is less free money on the table, but we still see a lot of attractive opportunities.”

Others are more nervous about prospects for the lower quality bonds. The likelihood of default for an issuer rated B- over three years is about 15-17 per cent, while for a CCC-rated credit default risk rises to 20-30 per cent over the same period.

“We are very cautious on CCC, only taking positions where we think an upgrade is likely, as this is the sector that will rally most in a bull market but will drop more in a downturn,” says Alain Krief, head of L/O Credit Corporate Investments at BNP Paribas AM. “It’s all about picking the right names at the right time. With still a 20 per cent probability of a double dip embedded in market prices, CCC is not the place to be because there is still only fragile growth. However we try to grasp some opportunities in this segment through in house credit research as the ratings houses are lagging the economy and tend to wait for results, often waiting a quarter before upgrading/downgrading the issuer.”

One risk to this equilibrium is any stoking of inflation. “Most worrying is inflation because central banks are aiming to increase inflation in order to help de-leveraging and anything above 5 per cent would be bad for bonds,” says Adam Cordery, head of UK and European Credit Strategies and fund manager of Schroder ISF EURO Corporate Bond Risks for corporate bonds.

“The main risk is the underlying governments bonds that credits are based on,” adds Mr Cordery. “Fears surrounding the Eurozone such as Euro banks collapsing and a double dip have forced investors to safe havens such as government bonds. However, we believe that this fear is starting to decrease which could lead to the government bond bubble deflating or possibly bursting.”

The Schroder fund is protected from rising gilt yields by an overweight in high credit spreading sectors and shorting German gilt futures.

There is also the risk of a further failure of a large bank. Banks account for 25 per cent of the European high yield market and some have highly subordinated debt that has fallen into the high yield space, but views on the sector differ widely. Some managers spy an opportunity in Basle III which will encourage banks to reduce their paper, some prefer to take exposure to off benchmark names such as Intesa San Paolo, BNP or SocGen rather than benchmark names like RBS and Banco Popolare as yields are similar but their risk profile is better, and some are avoiding the sector altogether, saying it is not their business to take a view on policy risk.

In contrast, some funds are significantly overweight the TMT sector, pointing out that 10 years ago it was predominately TMT names which had overspent and faced bankruptcy but paradoxically these companies are now in best shape with strong balance sheets, solid business plans and a more conservative approach to managing expansion than last time around.

Even so, Wesley Sparks, senior vice president, US Fixed Income Portfolio at Schroders, says he is already switching out of TMT, paper and chemicals and into more stable cashflow companies such as food and beverage and consumer stocks.“That healing part of the credit cycle has run its course.”

Most funds in this sector are fairly well diversified with 80-100 stocks, but conviction funds such as BlueBay and Nordea are in particularly high demand. BlueBay High Yield fund, for example, is one of only two high yield funds globally that still benefits from an S&P AAA rating. “The fund is differentiated from its peers by its strong focus on avoiding defaults, and on fundamental research with capital the cornerstone of the entire process,” says manager Anthony Robertson. “Protecting the investment capital is most important; capital appreciation should be the icing on the cake.”

It is a relatively concentrated absolute return fund with 70-90 stocks, at the low end of the broader peer group’s average holdings. “We have conviction about the stocks we hold,” says Mr Robertson. “The way to perform well in high yield is bottom up, qualitative rather than quantative. There is no point in having a beta-adjusted benchmark style, as this works in certain markets but is subject to significant default levels in a volatile environment.”

Investors are increasingly knowledgeable about the bond market and many advisers recommended high yield bonds earlier this year, switching allocations from equities and enabling clients to take advantage of the capital appreciation, making total returns of around 12 per cent year to date, compared with 6.5-7 per cent year to date in investment grade. Currently, some investors might be taking profits, but on a strategic allocation basis the asset class remains competitive and there are still strong inflows, albeit slightly flatter in recent months.

For example, Capital Four’s Mr Naef says Nordea’s fund had been enjoying huge inflows because of its long-term track record and selected high yield fund status with many private banks and wealth managers, but inflows flattened a little in August and September.

“We believe high yield bonds and loans should be core holdings in investor portfolios, particularly in this type of environment,” says Jim Keenan, lead portfolio manager at BGF US Dollar High Yield Bond Fund.

“In a slow-growth economy, we think it makes sense to focus on income. Today, you can get high-single-digit yields by owning high yield bonds and leveraged loans, which also come with growth potential and built-in inflation protection, as well as a lot more downside protection than you would have in the equity market. So, whereas some investors view high yield as a tactical play and relatively small percentage of their investment portfolio, we believe that allocation should be increased and even replace some of the equity exposure investors have had historically.”

Demand increasing as corporate situation improves

The asymmetric risk profile of the asset class means most wealth managers primarily rely on funds for exposure to this sector, rather than recommending individual names, but high yield continues to shine in the current low return environment. While the average yield in an investment grade portfolios has gone from 5 per cent at the beginning of the year to 3.5 per cent now, high yield has remained attractive at around 8 per cent compared with 8-9 per cent at the start of the year.

“We’ve been recommending to our clients to invest in high yield since the beginning of the year,” says Soma Rao, the head of fixed income, commodities and currencies for JP Morgan Private Bank in EMEA. “Corporate balance sheets are much cleaner than a few years back and companies have added to their cash positions. On the economic front, while our view is that growth is slow, we believe corporate earnings will keep chugging along.”

“Looking ahead we believe the default rates on high yield bonds are set to remain low for the foreseeable future,” agrees Johan Jooste, portfolio strategist at Merrill Lynch Wealth Management EMEA. “Default rates have reduced significantly, and companies have healthier balance sheets. Added to this, the market for high yield bonds is now vigorous so a business seeking to roll-over debt or issue new debt will usually find ready buyers.

“High yield bonds are relatively lowly valued compared to history. Investor risk appetite continues to increase. In a nutshell – the demand fundamentals for high yield bonds are good and the risk of an investor losing capital is low,” says Mr Jooste.

As well as funds, JP Morgan has a proprietary actively managed high yield strategy and also recommends individual names. In actively managed strategies, it is looking to invest in stronger rated high yield, that stay with BB average credit quality, not B and CCC, and they are mindful of total return. There is still an opportunity for spreads to tighten, says JP Morgan’s Mr Rao.

“Clients have been encouraged to look at high yield and emerging market debt as a way to boost returns,” he says. “Emerging market bonds are still performing strongly but investors need to be more careful about entry points both in [EM] yields and currencies, particularly in local currency bonds, which are now at their highest for a year.”

Sandro Naef, Capital Four