sHigh yield bond spreads have widened significantly and are now at levels not seen since early 2003, arguably presenting a rare window of opportunity for those who can stomach some volatility.
At 850bp over Government bonds, current spreads are over three times higher than at the lowest point in June 2007. The ten-year average is around 550bp, but the asset class fluctuates between bouts of euphoria and bouts of depression and over the last 10 years spreads have ranged from around 300-1000bp and default rates have ranged from less than 2 per cent to nearly 11 per cent. Currently, the market is pricing in an 8 per cent default rate, but the incidence of speculative-grade bond failure is 2.7 per cent.
Moody’s is predicting default in the high yield sector will rise to 4.9 per cent by the end of year, and to 7.4 per cent in 12 months’ time. The consensus among fund managers seems to be that this is an overstatement, and a moderate increase to perhaps 5-6 per cent in 12 months is more realistic.
Triggering defaults
One argument Moody’s raises is that covenants have been weaker and triggers for defaults are less onerous than in the past so companies could be in worse shape than they appear, defaults could be taking longer to materialise and lower recovery rates will result when the rot starts to show.
Seasoning will also impact debt taken on in 2006 and early 2007 at some point next year. “If you lend someone money they can probably survive for a year or two but the wheat is separated from the chaff in the second year,” points out Ryan Blute, vice president of European credit at Pimco.
“In years two and three we start to see if the business model is effective, whether they are delivering and can pay down their debt,” he adds.
One focus is to identify overcompensation. The speculative-grade market is prone to overcompensate for default risk at times, although there are short-term periods when this is not the case.
“We’re still of the view that we will see more defaults coming into the market with a drift wider in bond spreads,” says Paul Brain, manager of Newton’s European High Yield Bond Fund.
“What we’re looking for is an overshoot scenario. The market could get scared and factor in 10-11 per cent, so presenting a significant opportunity.” Brain expects to increase his weighting in high yielders from the current 9 per cent to 50 per cent in six months.
Trudie Rothery, credit investment specialist at Threadneedle, says a recurring question from investors focuses on the early 2000s when spreads went out to 1,000 basis points and they now often ponder whether they should wait until spreads again reach those kinds of levels.
However, Ms Rothery says that there were some very specific influences that contributed to spreads being so big at that time, firstly the terrorist attack on the Twin Towers and then the accounting scandals, exemplified by Enron and Worldcom. The market was also different in 2000, particularly Europe where telecoms were a disproportionate part of the market and suffered defaults.
While there may always be shocks around the corner, Ms Rothery concedes that now may be the time to start looking for potential opportunities. Economically sensitive cyclical stocks that a few weeks ago were not even on the radar may begin to offer pockets of value.
Dispersion in spreads
Opportunities are also presented by the dispersion in spreads between the top and bottom ends of the market, a gap which has been blown wide open. In June 2007, there were only 321bp separating the highest and lowest yields between the 10th and 90th percentile credit in the European high yield market. This has ballooned to 1172bp, a fruitful environment for bottom-up name selection
The risk is always of coming back into the market too late. “The market already factors in a significant risk premium,” says Grégoire Pesquès, head of credit management at Société Générale Asset Management in Paris, who expects companies to be a little disappointing, but also warns that the official default rate is a lagging indicator of performance.
“Investors should generally invest prior to the peak in defaults,” he says. “The worst year of rotation was in 1990-91, when the default rate was 10 per cent but that year high yield bonds returned 40 per cent.”
Despite poor visibility in the short-term, Mr Pesquès has therefore slowly increased his exposure to the market and built flexibility into the portfolio, for example by way of a bucket of CDS on iTraxx, and a focus on finding bonds that are liquid.
